pathfinder - icanig.org · 2018. 2. 20. · november 2017 diet professional level examinations...

THE INSTITUTE OF CHARTERED

ACCOUNTANTS OF NIGERIA

PATHFINDER

NOVEMBER 2017 DIET

PROFESSIONAL LEVEL EXAMINATIONS

Question Papers

Suggested Solutions

Marking Guides

Plus

Examiner‟s Reports

1

FOREWARD

This issue of the PATHFINDER is published principally, in response to a growing

demand for an aid to:

(i) Candidates preparing to write future examinations of the Institute of

Chartered Accountants of Nigeria (ICAN);

(ii) Unsuccessful candidates in the identification of those areas in which they

lost marks and need to improve their knowledge and presentation;

(iii) Lecturers and students interested in acquisition of knowledge in the relevant

subject contained herein; and

(iv) The professional; in improving pre-examinations and screening processes,

and thus the professional performance of candidates.

The answers provided in this publication do not exhaust all possible alternative

approaches to solving these questions. Efforts had been made to use the methods,

which will save much of the scarce examination time. Also, in order to facilitate

teaching, questions may be edited so that some principles or their application may

be more clearly demonstrated.

It is hoped that the suggested answers will prove to be of tremendous assistance to

students and those who assist them in their preparations for the Institute‟s

Examinations.

NOTES

Although these suggested solutions have been published under the

Institute‟s name, they do not represent the views of the Council of the

Institute. The suggested solutions are entirely the responsibility of their

authors and the Institute will not enter into any correspondence on them.

2

TABLE OF CONTENTS

FOREWARD

PAGE

1

CORPORATE REPORTING 3

ADVANCED TAXATION 40

STRATEGIC FINANCIAL MANAGEMENT 75

ADVANCED AUDIT AND ASSURANCE 108

CASE STUDY 134

3

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF NIGERIA

PROFESSIONAL LEVEL EXAMINATION – NOVEMBER 2017

CORPORATE REPORTING

Time Allowed: 31

/4 hours (including 15 minutes reading time)

INSTRUCTION: YOU ARE REQUIRED TO ANSWER FIVE OUT OF SEVEN

QUESTIONS IN THIS PAPER

SECTION A: COMPULSORY QUESTION (30 MARKS)

QUESTION 1

The following are the financial statements of Papa, Tata and Chebe, all Plcs.as at

March 31, 2017:

Papa Tata Chebe

N‟m N‟m N‟m

Assets:

Tangible non-current assets 1,280 440 280

Investment in Tata 413 - -

Investment in Chebe 60 - -

Current assets 531 190 130

Total assets 2,284 630 410

Equity and liabilities:

Share capital of N1 each 800 240 200

Share premium 150 20 30

Revaluation reserve 90 - -

Retained earnings 390 210 94

Total equity 1,430 470 324

Non-current liabilities 640 30 16

Current liabilities 214 130 70

Total equity and liabilities 2,284 630 410

4

Papa acquired the following shareholdings in Tata and Chebe

Date of

acquisition

Holding

acquired

Fair value of

net assets

Purchase

consideration

N‟m N‟m

Tata April 1, 2014 30% 325 120

April 1, 2016 50% 460 260

Chebe April 1, 2016 25% 200 60

You are also provided with the following information, which will be relevant to the

consolidated financial statements of Papa Plc.

(i) None of the companies has issued any additional share capital since April 1,

2014.

(ii) The financial statements of Papa have not yet been adjusted for the gain or

loss arising on gaining control of Tata.

(iii) At April 1, 2014, the carrying value of the net assets of Tata was the same as

their fair value of N325million.

(iv) Papa Plc. wishes to use the full fair value method of accounting for the

acquisition of Tata, and at April 1, 2016 the estimated value of goodwill

attributable to non-controlling interests was N3million. The estimated fair

value of the initial investment in 30% of the shares of Tata was N150million

at March 31, 2017.

(v) Included in the tangible non-current assets of Tata is land, valued at cost

which on March 31, 2017 had a fair value of N25million in excess of its

carrying value. There has been no subsequent significant change in that

value.

(vi) At April 1, 2016 the fair value of Chebe‟s land was N16million in excess of its

carrying value. There has been no subsequent significant change in that

value.

(vii) Goodwill arising on acquisition is tested for impairment at each year end. At

March 31, 2017 an impairment loss of N15million was recognised for Tata.

(viii) There has been no impairment of the investment in Chebe.

Required:

Prepare the consolidated statement of financial position of Papa group as at March

31, 2017. (Total 30 Marks)

5

SECTION B: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS

IN THIS SECTION (40 MARKS)

QUESTION 2

The summarised comparative financial statements of Odua Plc. for the year ended

December 31, 2016 and 2015 are as follows:

Statements of profit or loss and other comprehensive income for the year ended

December 31

2016

(N‟m)

2015

(N‟m)

Revenue 550 400

Cost of sales (400) (200)

Gross profit 150 200

Operating costs (72) (60)

Operating profit 78 140

Investment income – (Note 2)

(Loss)/Gain on revaluation of investments held at fair value

Profit/Loss (10) 20

Finance costs (10) (6)

Profit before taxation 58 154

Income tax expense (8) (30)

Profit for the year 50 124

Other comprehensive income

(Amounts that will not be reclassified to profit or loss)

Revaluation losses on property plant & equipment (90) -

(Loss)/total comprehensive income for the year (40) 124

Statement of Financial Position as at 31 December

Assets N N N N

Non-current assets:

Property, plant and equipment 430 490

Investments at fair value through profit or loss 70 80

500 570

Current assets:

Inventory 80

38

Trade receivables 104

56

Bank - 184 20 114

Total assets 684 684

Equity and liabilities

Equity:

Equity shares of N0.50 each 240 240

6

Revaluation reserve 20 110

Retained earnings 180 130

440 480

Non-current liabilities:

Bank loan 100 100

Current liabilities:

Trade payables 100

78

Bank overdraft 40

-

Current tax payable 4 144 26 104

Total equity and liabilities 684 684

The following additional information is relevant:

(i) The Managing Director is of the view that the company has retained its book

value and therefore has not suffered any deterioration in performance from

2015 to 2016. This statement was made in the process of appraising the new

strategy introduced by the company which he believes has not failed.

(ii) Odua Plc. has traditionally been very profitable, but in recent years has been

finding it difficult to keep up its sales level due to the effects of online

shopping. Basically, it finds out that more customers are buying directly

online from suppliers and cutting out the middleman, which includes Odua

as a wholesaler. To cope with this situation, on January 1, 2016 Odua

launched a

strategy of cutting its prices in the hope that this would generate additional

sales volume and profits.

(iii) To support the new strategy and allow faster movement of goods, a new

product movement and control system was commissioned and installed on

January 1, 2016 at a cost of N40million. This is being depreciated over a 5

year useful economic life. The old system was disposed off for zero

consideration on the same date, but had been carried at N15million at the

date of disposal. The loss was taken to cost of sales, as well as the

depreciation. No other non-current assets were acquired or disposed in

either of the two years.

(iv) The share price has declined from N2.80 per share on December 31, 2015 to

N1.60 per share on December 31, 2016 and the Managing Director is unable

to attribute reasons for the decline in the share prices.

You are required to:

7

Analyse the financial statement of Odua Plc. by evaluating and interpreting

the underlisted ratios under relevant headings of profitability, efficiency,

short term liquidity and long term solvency and stability as well as stock

market performance for each financial year taking into consideration the

additional information in (i) – (iv) above:

Gross Margin Inventory Days

Net Margin Receivables Days

ROCE Payables Days

ROE Earnings per share

Current Ratio Price earnings ratio

Acid Test Gearing

Interest cover (Total 20 Marks)

QUESTION 3

Funda Plc. is a listed entity based in Nigeria, a utility service company and is

involved in the supply of water, electricity and cable services to domestic and

industrial consumers. The directors of Funda Plc. have prepared draft financial

statements for the year ended June 30, 2017 and have stated that these have been

prepared in accordance with IFRS. The financial statements are to be used in

support of a loan application. Funda Plc. employees own 5% of the ordinary shares

of the company. The employees‟ representatives have expressed concern about the

loan application and are seeking advice on certain of the policies Funda Plc. has

used in drafting the financial information.

The draft income statement for the year ended June 30, 2017 is:

N‟m

Revenue 410.0

Cost of sales (275.0)

Gross profit 135.0

Other operating costs (65.0)

70.0 Profit before taxation

The employees‟ representatives require an explanation on the following:

Sale of water filters

Funda Plc. manufactures industrial water filters. On December 31, 2016 it sold a

batch of 30 filters to a steel maker. Funda Plc. faced stiff competition to secure this

8

order. As part of its marketing offer, Funda Plc. provided a volume discount of 20%

from the market price of the filters. A further term of the contract was that Funda

Plc. has granted the steel maker a put option on the filters. The option entitles the

steel company to require Funda Plc. to repurchase the filters after 6 years for 35% of

the price paid on the initial transaction. The expected economic life of the filters is

10 years. At the date of the sale transaction, the repurchase option was expected to

be „in the money‟. The filters normally sell for ₦625,000 each at which price Funda

Plc. achieves a profit margin of 36%. The steel company has paid for the filters in

full and Funda Plc. has recognised the revenue and costs of manufacture in profit

or loss.

Connection fees

Funda Plc. supplies electricity to domestic consumers and charges customers a

connection fee before it will connect the customer to the electricity supply network.

This connection fee is refundable to the customer if and when the customer decides

that the electricity supply is no longer required. There is no minimum notice period

that the customer must give Funda Plc. of its request to disconnect. Funda Plc. may

deduct the cost of disconnecting the customer from the amount refundable. Funda

Plc. has many long-established customers that are not expected to request

disconnection in the foreseeable future. Fees charged in the year ending 30 June,

2017 were ₦5m (2016: ₦4m). These amounts have been credited to profit or loss.

Activation fees

Funda Plc. supplies a range of digital cable services including telephone, internet

access and cable TV. The company charges its customers a one-time activation fee

to enable them to get a number and access to the cable network. This fee is non-

refundable. ₦7m in such fees have been credited to profit or loss in 2017 (2016:

₦4m).

Deposits

Funda Plc. supplies domestic electrical goods to customers. Customers must pay a

deposit of 25% of the purchase price when placing an order. The remaining 75% is

payable on delivery of the appliance. Funda Plc. retains the deposit if the customer

cancels the order. If Funda Plc. is unable to fulfil the order the deposit is repayable

in full. Funda Plc. recognises the deposits as revenue in profit or loss when the

order is placed. Revenue includes ₦10m in respect of these deposits relating to

orders in the year. 90% of these orders have been filled.

9

Required

Prepare a report which explains the suitability of Funda Plc. accounting policies for

the transactions listed above and recommend the correct treatment where

appropriate. (Total 20 Marks)

QUESTION 4

Enugun Industries Limited

Atikun has recently been appointed as Financial Controller to Enugun Industries

Limited. Until a month ago, Enugun Industries had a Finance Director, who

resigned suddenly, due to ill health. Since Atikun joined the company, he has

learned that his resignation was related to stress caused by a series of

disagreements with the Managing Director about the performance of the business.

The directors have not yet appointed a replacement.

It is now March 2015 and you have been asked to finalise the financial statements

for the year ended December 31, 2014. The draft statement of profit or loss extract

and statement of financial position are shown below:

Draft statement of profit or loss for the year ended December 31, 2014

₦‟000

Profit before tax 2,500

Draft statement of financial position as at December 31, 2014

₦‟000

Property, plant and equipment 12,000

Current assets 3,500

Total assets 15,500

Share capital 2,000

Retained earnings 6,000

Equity 8,000

Non-current liabilities 5,000

Current liabilities 2,500

Total equity and liabilities 15,500

During the year ended December 31, 2014 Enugun Industries entered into

the following transactions.

(i) Just before the year-end Enugun Industries signed a contract to

deliver consultancy services for a period of 2 years at a fee of

₦500,000 per annum. The full amount of this fee has been paid in

advance and is non-refundable.

10

(ii) Enugun Industries has constructed a new factory. The construction

has been financed from the pool of existing borrowings. Land at a

cost of ₦1.8million was acquired on February 1, 2014 and

construction began on June 1, 2014. Construction was completed on

September 30, 2014 at an additional cost of ₦2.7million. Although

the factory was usable from that date, full production did not

commence until December 1, 2014. Throughout the year, the

company‟s average borrowings were as follows:

Amount Annual

interest rate

₦ %

Bank overdraft 1,000,000 9.75

Bank loan 1,750,000 10

Loan notes 2,500,000 8

An amount of ₦450,000 has been included in property, plant and

equipment in respect of borrowing costs relating to the construction

of the factory. The useful life of the factory has been estimated at

20 years. No depreciation has been charged for the year. The

reason for this is that the factory has only been in use for one

month and that the depreciation charge would be immaterial.

(iii) A blast furnace with a carrying amount at January 1, 2014 of ₦3.5

million has been depreciated in the draft financial statements on

the basis of the remaining life of 20 years. In December 2014, the

directors carried out a review of the useful lives of various

significant items of plant and machinery, including the blast

furnace and came to the conclusion that the useful life of the

furnace was 20 years at December 31, 2014. The reasoning behind

this judgement was that the lining of the furnace had been

replaced in the last week of December 2014 at a cost of ₦1.4

million. Provided that the lining is replaced every five years, the life

of the furnace can be extended accordingly. You have found a

report, commissioned by the previous Finance Director and

prepared by a firm of asset valuation specialists, which assesses the

remaining useful life of the main structure of the furnace at

January 1, 2014 at 15 years and the lining of the furnace at 5 years.

You have also found evidence that the Managing Director has seen

this report.

Atikun has had a conversation with the Managing Director who told

him, “We need to make the figures look as good as possible so I

hope you‟re not going to start being difficult. The consultancy fee is

non-refundable so there‟s no reason why we can‟t include it in full.

I think we should look at our depreciation policies. We‟re writing off

our assets over far too short a period. As you know, we‟re planning

to go for a stock market listing in the near future and being prudent

11

and playing safe won‟t help us do that. It won‟t help your future

with this company either.”

Required:

a. Explain the required IFRS accounting treatment of these issues,

preparing relevant calculations where appropriate. (16 Marks)

b. Discuss the ethical issues arising from your review of the draft

financial statements and the actions that you should consider.

(4 Marks)

(Total 20 Marks)

SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE

QUESTIONS IN THIS SECTION (30 MARKS)

QUESTION 5

Tinubun Plc., a public limited company, operates two pension plans.

Pension Plan 1

The terms of the plan are as follows:

(i) Employees contribute 6% of their salaries to the plan

(ii) Tinubun Plc. contributes, currently, the same amount to the plan for the

benefit of the employees

(iii) On retirement, employees are guaranteed a pension which is based upon

the number of years‟ service with the company and their final salary.

(iv) This plan was closed to new entrants from October 31, 2016 but which was

open to future service accrual for the employees already in the scheme.

The following details relate to the plan in the year to October 31, 2017:

N„m

Present value of obligation at November 1, 2016 200

Present value of obligation at October 31, 2017 240

Fair value of plan assets at November 1, 2016 190

Fair value of plan assets at October 31, 2017 225

Current service cost 20

Pension benefits paid 19

Total contributions paid to the scheme for year to October 31, 2017 17

12

Actuarial gains and losses are recognised in the Statement of Other Comprehensive

Income.

Pension Plan 2

Under the terms of the plan, Tinubun Plc. does not guarantee any return on the

contributions paid into the fund. The company‟s legal and constructive obligation is

limited to the amount that is contributed to the fund. The following details relate to

this scheme

N‟m

Fair value of plan assets at October 31, 2017 21

Contributions paid by company for year to October 31, 2017 10

Contributions paid by employees for year to October 31, 2017 10

The discount rates for the two plans are:

October 31, 2017 November 1, 2016

Discount rate 6% 5%

Required:

a. Explain the nature of and differences between a defined contribution plan

and a defined benefit plan with specific reference to the company‟s two

schemes. (7 Marks)

b. Show the accounting treatments for the two Tinubun Plc. pension plans for

the year ended October 31, 2017 under IAS 19 „Employee Benefits‟.

(8 Marks)

(Total 15 Marks)

QUESTION 6

Eko Exports Limited

The following information pertains to Eko Exports Limited (EEL) for the financial

year ended December 31, 2016:

(i) A customer who owed N1million was declared bankrupt after his

warehouse was destroyed by fire on February 10, 2017. It is expected

that the customer would be able to recover 50% of the loss from the

insurance company.

(ii) An employee of EEL forged the signatures of directors and made cash

withdrawals of N7.5million from the bank. Of these, N1.5million were

withdrawn before December 31, 2016. Investigations revealed that an

employee of the bank was also involved and therefore, under a

13

settlement arrangement, the bank paid 60% of the amount to EEL on

January 27, 2017.

(iii) EEL has filed a claim against one of its vendors for supplying defective

goods. EEL‟s legal consultant is confident that damages of N1million

would be paid to EEL. The supplier has already reimbursed the actual

cost of the defective goods.

(iv) A suit for infringement of patents, seeking damages of N2million, was

filed by a third party. EEL‟s legal consultant is of the opinion that an

unfavourable outcome is most likely. On the basis of past experience, he

has advised that there is 60% probability that the amount of damages

would be N1million and 40% likelihood that the amount would be N1.5

million.

Required:

Advise EEL about the amount of provision that should be incorporated

and the disclosures that are required to be made in the financial

statements for the year ended December 31, 2016.

(Total 15 Marks)

QUESTION 7

Corporate reporting by listed companies in Nigeria is evidenced by the annual

report defined as a comprehensive report on a company‟s activities throughout the

preceding year.

The directors of Mugono Plc would want to know the content of an annual report.

They are not sure of the difference between mandatory and voluntary disclosures in

the annual report of the company.

Required:

Write a report to the directors of Mugono Plc

a. Highlighting the components included in annual report. (4 Marks)

b. Showing the following:

i. THREE advantages of mandatory disclosures in annual report;

(3 Marks)

ii. FOUR advantages of voluntary disclosures in annual report.

(4 Marks)

iii. TWO limitations of information provided on a voluntary basis.

(2 Marks)

(For clarity in presentation) (2 Marks)

(Total 15 Marks)

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SOLUTION 1

PAPA PLC

Consolidated statement of financial position as at 31 March 2017

₦m

Assets

Tangible non-current assets (W4) 1,745

Intangible non-current assets – goodwill 45 – 15 (W3) 30

Investment in associate (W5) 95

Current assets (531 + 190) 721

Total Assets 2,591

Equity and liabilities:

Share capital of ₦1 each 800

Share premium 150

Revaluation reserve 90

Retained earnings (W6) 438

1,478

Non-controlling interest (W7) 99

1,577

Non-current liabilities (640 + 30) 670

Current liabilities (214 + 130) 344

Total Equity and liabilities 2,591

Workings

(W1) Tata retained profits

₦m

Fair value of net assets at 1 April 2016 460

Fair value adjustment for land (25)

Carrying value of net assets 435

Share capital 240

Share premium 20

(260)

Therefore retained earnings at 1 April 2016 175

₦m

Carrying value of net assets at 1 April 2014 325

Share capital 240

Share premium 20

(260)

Therefore retained earnings at 1 April 2014 65

15

(W2) Gain or loss on acquiring control of Tata

₦m ₦m

Fair value of initial investment in Tata 150

Initial cost of investment 120

Share of retained earnings 1 April 2014 – 1 April 2016

(= 30% (175 – 65) – see W1

33

Carrying value of investment in Tata as associate 153

Loss recognised on gaining control of Tata (3)

This loss has not yet been recognised in the individual financial statements

of Papa Plc; it must therefore be included in the calculation of group

reserves (see Working 8).

(W3) Goodwill in Tata at acquisition

₦m

Fair value of initial investment at acquisition 150

Cost of additional shares 260

Total cost 410

Fair value of net assets acquired (80% 460) 368

Goodwill at acquisition attributable to Papa 42

Goodwill attributable to NCI 3

To T Total goodwill at acquisition date 45

Goodwill in statement of financial position: There has been impairment of

₦15 million in goodwill. This is apportioned between the interests of the

equity owners of Papa and NCI in the ratio 80:20.

Impairment of goodwill attributable to parent = ₦15m 80% = ₦12 million

Impairment of goodwill attributable to NCI = ₦15m 20% = ₦3 million.

(W4) Tangible non-current assets

₦m

Papa 1,280

Tata 440

Fair value adjustment 25

1,745

16

(W5) Net Assets of the Subsidiary - Chebe

Reporting Acquisition Post

Date Date Acquisition

N‟M N‟M N‟M

Share capital of N1 200 200 -

Share Premium 30 30

Retained Earnings 94 94

Fair vale adjustment 16 16

324 216 140

Investment in Chebe (Associate)

₦‟m

Costs 60

Share of post acquisition

retained profit (25% x 140)

35

Investment 95

OR

₦‟m

Share of Chebe net assets (24% x 324) 81

Fair value adjustment (25% x 16) 4

Goodwill (60 – (200 x 25%) 10

95

(W6) Consolidated retained earnings

₦m

Papa (given) 390

Tata post-acquisition retained earnings

(210 – 175 (W1)) × 80% 28

Loss on acquiring control (W2) (3)

Goodwill impairment attributable to parent (W3) (12)

Share of post acquisition profits of associate (W5) 35

438

(W7) Non-controlling interest in Tata

₦m

Book value (20% × 470) 94

Fair value adjustment (20% × 25) 5

Goodwill (3 – impairment 3) (W3) 0

99

17

EXAMINER‟S REPORT

This question tests candidates‟ understanding of the preparation of consolidated

statement of financial position involving steps acquisition and associates.

About 99% of the candidates attempted the question and the performance was

below average.

Commonest pitfall is the inability of the candidates to compute goodwill on

acquisition, retained earnings and non-controlling interest. Also, candidates were

not able to distinguish an associate company from subsidiary company.

Candidates are advised to master all aspects of group financial statements as this is

always the compulsory question in this paper. ICAN Study Text should be deeply

studied to improve performance in future examinations.

Marking guide

Marks

i. Statement of Financial Position 10

ii. Working Notes 20

Total mark obtainable 30

SOLUTION 2

Computation Of Relevant Ratios For Odua Plc

Categories Ratios Formula 2016 N‟ m 2015 N‟ m

Profitability Gross Profit

Margin

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡

𝑆𝑎𝑙𝑒𝑠× 100

150

550𝑥100=

27.27%

200

400× 100

= 50%

Net Profit

Margin 𝑃𝐵𝐼𝑇𝑆𝑎𝑙𝑒𝑠

× 100

68

550× 100

= 12.36%

160

400× 100

= 40.00%

ROCE 𝑃𝐵𝐼𝑇

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑× 100

68

540× 100

160

580× 100

= 27.59%

18

= 12.59%

ROE 𝑃𝐴𝑇

𝐸𝑞𝑢𝑖𝑡𝑦 × 100

50

440× 100

= 11.36%

124

480× 100%

= 25.83%

Short-term

Liquidity

Current Ratio 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

184

144

= 1.28:1

114

104

= 1.10:1

Acid test ratio 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

184 − 80

144

=0.72:1

114 − 38

104

= 0.73:1

Long- term

Liquidity

Interest Cover 𝑃𝐵𝐼𝑇

𝐹𝑖𝑛𝑎𝑛𝑐𝑒 𝐶𝑜𝑠𝑡

68

10

= 6.8 times

160

6

= 26.67 times

Gearing Ratio 𝐷𝑒𝑏𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑× 100

100

540× 100

= 18.52%

100

580× 100

= 17.24%

Efficiency

Ratio

Inventory Days 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠

× 365 𝑑𝑎𝑦𝑠

80

400× 365 𝑑𝑎𝑦𝑠

= 73 days

38

200× 365 𝑑𝑎𝑦𝑠

= 69 days

Receivable

Days

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝑆𝑎𝑙𝑒𝑠


104

550× 365 𝑑𝑎𝑦𝑠

=69days

56

400× 365 𝑑𝑎𝑦𝑠

=51 days

Payable days 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒


100

400× 365 𝑑𝑎𝑦𝑠

= 91 days

78

200× 365 𝑑𝑎𝑦𝑠

= 142 days

Stock

market

performance

EPS 𝑃𝐴𝑇

𝑁𝑜 𝑜𝑓𝑠𝑕𝑎𝑟𝑒

50

480 𝑠𝑕𝑎𝑟𝑒𝑠

=0.1042 kobo

124

480 𝑠𝑕𝑎𝑟𝑒𝑠

= 0.2583kobo

19

Price earning

ratio

𝑀𝑃𝑆

𝐸𝑃𝑆

1.6

0.104

= 15.38 times

2.8

0.258

= 10.84 times

PBIT =

PAT =

Profit before interest and tax

Profit after Tax

MPS = Market Price Per Share

Interpretation and discussion of the Ratios

Profitability:

All profitability ratios declined in 2016. Gross margin dropped from 50% in 2015 to

27.27% in 2016. This implies that the cost of sales of the company has increased in

2016 than it was in 2015. There was also a drop in net profit margin from 40% in

2015 to 12.36% in 2016. Return on Capital Employed declined from 27.59% to

12.59% while ROE dropped from 25.83% in 2015 to 11.36% in 2016.

Gross profit has declined from N100m to N75m, the latter figure being N90m if the

loss on disposal were excluded from cost of sales. This is an underlying decline of

10%. This is not a disaster. It is possible that the new strategy and system took

some time to gain attraction in the market and it would be very useful to see month

by month figures to ascertain if there was an improvement over the years. It is also

entirely possible that the result would have been much worse had the new strategy

not been implemented. After all, the real comparison is not with last year, but with

what this year would have been, had the change not occurred. This is probably

impossible to know.

Net margins are also down substantially (from 41% to 12.4%, the latter increasing to

17.8% excluding the loss on disposal). If we further adjust these figures to exclude

the gains and losses on fair value investments, the figures are 19.6% (2016) and

36% (2015). This is a smaller decline, but still significant.

The increase in operating costs is not surprising considering that revenue has

increased by 37.5% in value terms and much more in unit terms due to the

reduction in prices. Hence, we can conclude that operating cost efficiency had not

materially deteriorated.

Short term Liquidity:

20

The current ratio has actually improved from 1.1:1 to 1.28:1, however the levels are

still very poor. The acid test ratio looks even worse, declining from 0.73:1 to 0.72:1.

It seems that the company‟s cash position is bad, with a positive N20m cash

balance turning into a negative N40m over the year. Apart from the bank overdraft,

trade payables seem to be financing much of the company‟s liquidity needs.

However, it is important to bear in mind that the company bore large one-off

investments in 2016, particularly the new N40m control system. This was financed

from cash flow, as neither equity nor borrowings have increased.

Also, it is likely that the increase in inventory and receivable (both absorbing cash)

are related to the expansion of sales levels, and may not be repeated.

However, that said, it is vital that the company examines closely its future cash flow

needs and considers raising new equity or debt as protection against unexpected

events. The company is dangerously exposed at present.

It would be important to know when the bank loan is due for repayment, as the

company is not in a position to repay it at present. Presumably the investments

could be sold if necessary. This provides a cushion of support.

Long term Solvency and Stability

The interest cover of the company is about 27 times in 2015 which shows a good

performance while the interest cover dropped drastically to 6.8 times in 2016 which

must have arisen as a result of poor performance that occurs in the period.

Furthermore, the gearing ratio of the company increased from 17.24% in 2015 to

18.52% in 2016. This still depicts a better performance of being lowly geared.

Efficiency:

Although there have been significant increases in the figures for inventory,

receivables and payables, when expressed as a percentage of revenue and cost of

sales as appropriate, the increases are not that large.

The inventory days in 2016 was 73 days compared to 2015 of 69 days in 2016,

while the receivable days was 69 days in 2016 which is higher compared to 2015 of

51 days. Payables are being settled more quickly than 2015, although from a very

high base. It is important to guard against risks of being charged higher prices if

payment is slow. In the case of inventory, obsolescence may be a risk, depending

on the type of product being stored. Tighter inventory management reduces this

risk.

21

Stock market performance

Earnings per share and price earnings ratio are measures of how well the company

performs in the market. The earnings per share of the company declined in 2016

when compared the figure of 0.10 kobo in 2016 with 0.26kobo of 2015. The

company experienced decline in both market price and earnings per share thereby

showing an increase in price earnings ratio from 10.84 to 15.38.

Overall Comment:

From the analysis of the financial statements supplied and the ratios calculated, it

is clear that the performance of Odua Plc has deteriorated in 2016. Therefore, the

company should focus on increasing sales, maintaining its margins, and controlling

liquidity very tightly through strong working capital management.

EXAMINER‟S REPORT

The question tests candidates understanding of ratio analysis regarding the

identification of relevant ratios, computation and interpretation of identified ratios.

About 94% of the candidates attempted the question and the performance of some

of them was above average.

Commonest pitfall for candidates in answering the question was their inability to

appropriately classify the ratios under the specified categories. The overall

comment and conclusion were ignored by most candidates.

Candidates are advised to prepare very well on this area of analysis and

interpretation of the ratio as this is a required knowledge at the final level of the

examination.

Marking guide

Marks

a. Classification 31

/4

b. Formula 61

/2

c. Calculation (each year) 61

/2

d. Interpretation 31

/4

e. Conclusion/Overall comment ½

20

22

SOLUTION 3

Date:

To: Employees representative of Funda Plc.

From: Financial Controller

Subject: Accounting policies used by Funda Plc

(a) Suitability of accounting policies

For an accounting policy to be suitable, it had to meet up with the following

criteria.

i. It has to conform with regulatory procedures of Standards

Organisation of Nigeria (SON), NAFDAC, etc.

ii. The policy must meet up with current accounting treatment as laid down in

IAS, IFRS, etc. as follows: (IAS 8 - Accounting Policies, changes in Accounting

Estimates and Errors). I write to explain the suitability and treatment of

specific accounting policy matters which were used in the computation of

the financial information meant for loan application.

- Relevant to the decision making needs of users, and

- Reliable in the financial statements:

- Represent faithfully the results and financial position of the entity.

- Reflect the economic substance of transactions and other events,

and not merely the legal form;

- are neutral. i.e free from bias

- Are prudent; and

- Are complete in all materials respects

iii. Documentation procedures as specified in the operating manual and

Auditors suggestions should be reflected in the accounting policies of

the company.

iv. Funda Plc accounting policies should facilitate accounting system

audit.

v. Areas of efficiency improvement in the system should be reflected in

the accounting policy.

vi. Accounting policy would aid better understanding by the users of

financial statement.

vii. Further explanations, clarifications in the treatment of specific

transactions mentioned in the account.

viii. Accounting policies should be consistently applied every year and

reflect changes (if any).

23

ix. Since no company operates in isolation accounting policies should

form the basis of comparison with the financial statements of

companies in the same industry.

(b) Accounting treatment

Sales of water filter – (IAS – Leases)

i. It is a sale and repurchase arrangement

ii. Volume discount should be deducted to arrive at the net income (that

is N625,000) less N125,000.

iii. Put option is an example of a financial instrument that provides

finance for six years.

iv. N500,000 net payment can be recognised as revenue/sales/income.

v. Put-option can be defined as a contract that gives the purchaser the

right but not the obligation to sell a specified quantity of a particular

financial instrument, commodity, foreign currency etc at a specified

price (strike price) during a specified period.

vi. N175,000 (i.e. 35% of N500,000) is a premium to compensate the

buyer for the risk of payment under the option.

vii. N29,166.67 (N175,000 ÷ 6) should be debited to Profit or Loss

annually for six years in respect of a filter. This amount should be

provided for and debited to Profit or Loss and such provision should

be recognised as part of current liability in statement of financial

position.

viii. Depreciation should be provided and debited to Profit or Loss.

ix. Depreciation of N50,000/year/unit of filter in each year for six years

should be debited to Profit or Loss. N(500,000 10 = N50,000)

x. The item is part of inventory when it is collected back at the end of six

years and classified under current asset in the statement of financial

position.

xi. The inventory should be valued at N200,000 (N500,000 – N300,000)

(50,000 x 6 years) = N300,000 at net realisable value (NRV)

Connection fee

- The refundable connection fee should not be credited to Profit or Loss

because of its nature as refundable. (IAS 18 – Revenue)

- Only the cost of disconnection should be credited to Profit or Loss as

income/revenue/sales.

- The amount of N4m in 2016 and N5m in 2017 should be recognised as

contingent liability in the Statement of Financial Position (IAS 37 –

Provisions, contingent Liabilities and contingent Assets).

24

- Amount credited to Profit or Loss in the account is wrong.

Activation fees

- The treatment gives to the transaction as credit to Profit or Loss is in

order/correct.

- DR: Bank/cash CR: Activation fee account

Deposits

- Recognition of deposits as revenue in the statement of profit or loss when

orders are placed is wrong.

- N9m (90% of N10m) should be recognised as sales (fulfilled order).

- N1m (unfulfilled order), i.e. 10% of N10m is not revenue but a liability and

should be shown under appropriate heading in the Statement of Financial

Position.

Conclusion/Closing

Would you demand for further clarification do not hesitate to contact me

Name and Signature

EXAMINER‟S REPORT

This question tests candidates‟ knowledge of report writing, suitability of the

accounting policies on practical situation and correct treatment of specified

transactions.

About 36% of the candidates attempted the question and performance was

generally poor and below average.

The commonest pitfall was that most candidates ignored the report aspect of the

question and could not explain the suitability of accounting policies.

Candidates are advised to pay particular attention to reporting aspect of this

subject and to deeply understand the application of accounting standards to

practical situations.

25

Marking guide

(a) Report format Mark Mark

- To & Fro/Date 1

- Subjects 1

- Opening 1

- Closing remark/comment 1

- Remark & signature 1 5

(b) Suitability (Any five points mentioned) 5

(c) Treatment 2 marks for each points 10

Total 20

SOLUTION 4

(a) Scenario I

Criteria for revenue recognition

For revenue to be recognised the following criteria must be satisfied:

The entity had transferred to the buyer the significant risk and

reward of ownership.

The amount of revenue is capable of being measured reliabily

The cost incurred can be measured reliably.

The stage of completion of the transaction at the reporting date can

be measured reliably.

The following criteria are not satisfied in the consultancy contract, hence, the

full amount of N1,000,000 is to be recognised as LIABILITY: OR NON

CURRENT LIABILITY. NONE is to be recognised in the REVENUE ACCOUNT

Scenario II

Borrowing costs directly attributable to construction of an asset which takes

long period to get ready for its intended use should be capitalised as part of

the cost of the asset. Although, borrowing costs were incurred throughout

the year, capitalisation commences when project for which the borrowing

was contracted is complete. In the case of general borrowings, the

calculation of amount to capitalise is based on weighted average cost of

borrowing.

Capitalisation by using Weighted Average of the borrowing costs

26

Capitalisation Rate = 472,500

5,250,000× 100

= 9%

Computation of interest on borrowing:

N N

Land @ cost 1,800,000

Interest (9% x 1,800,000 x 8

/12

) 108,000

Construction work 2,700,000

Interest (9% x 2,700,000 x 4

/12

) 81,000

Total interest capitalised 189,000 89,000

Total cost of assets 4,689,000

The borrowing costs capitalised is to be reduced by (450,000 – 189,000)

= N261,000

N261,000 is to be expended in addition to the interest charge for the year,

as they are not to be capitalised with the asset acquired.

Computation of the depreciation to be charged

𝐷𝑒𝑝 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐴𝑠𝑠𝑒𝑡𝑠−𝐶𝑜𝑠𝑡 𝑜𝑓 𝐿𝑎𝑛𝑑

𝑁𝑜 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

12

3

= 4,689,000−1,800,000

20 ×

3

12

= N36,112.5

The carrying amount of assets constructed at year end

N(4,689,000 – 36,112.5)

= N4,652,887.5

Type of borrowings Amount

N

Rate(%) Hash

total

N

Bank overdraft 1,000,000 9.75 97,500

Bank loan 1,750,000 10 175,000

Loan notes 2,500,000 8 200,000

5,250,000 472,500

27

Scenario III

Depreciation of the blast furnace has been based on an estimated useful life

of 20 years. This is at variance with a report by a qualified expert.

Where estimates have been prepared by qualified professional, then

the professional valuers estimates to be used is 15years.

Carrying amount of assets N3,500,000

Estimated useful life 20 years

Depreciation charged N175,000

Using professional valuer‟s estimate of 15 years the depreciation to be

changed is

3,500,000

15

Depreciation to charges N233,333.33

Depreciation undercharged = N(233,333.33 – 175,000)

= N58,333

Additional depreciation of 58,333 is to be charged to the account in 2014

The lining which was replaced in the last week of the year will not attract

any depreciation for the year.

Revised Financial Statements

Statement of Profit or Loss Extract for the year ended December 31, 2014

N‟000 N‟000


Consultancy agreement 1,000

Over capitalised interest 261

Undercharged depreciation 58.33

(1,319.33)

Revised profit 2,180.67

28

Statement of Financial Position as at December 31, 2014

(b)

Ethical Issues

The following are ethical issues arising from the scenario above:

Previous Financial Controller (FC) resigned as a result of pressure from

Managing Director (MD).

MD pressured the FC to compute depreciation with an unrealistically long

useful life

MD pressured FC to present the favourable financial statements in favourable

light preparatory to stock market listing.

Possible courses of actions by the FC

Discuss with the MD about compliance with reporting standards

Explain to the MD that as a professional, you are bound by ethical code

Consider speaking with other Directors or Audit Committee (if any)

If all action fails, then consider resigning/seeking alternative employment.

EXAMINER‟S REPORT

The question tests the candidates‟ understanding and application of criteria for

revenue recognition, change of accounting policies, computation of average, cost of

borrowings and ethical issues confronting accountants in the preparation of

financial statements.

About 57% of the candidates attempted the question but they demonstrated poor

understanding of the requirement. Their performance was generally poor.

Draft Adjustment Revised

N‟000 N‟000 N‟000

Property, Plant & Equipment 12,000 (319.33) 11,680.67

Current assets 3,500 3,500

Total assets 15,500 1,518.67

Share capital 2,000 2,000.00

Retained earnings 6,000 (1,319.33) 4,680.67

8,000 6,680.67

Non-current liability 5,000 500 5,500.00

Current liability 2,500 500 3,000.00

15,500 15,180.67

29

The commonest pitfall was the inability of the candidates to recognise the

applicable timing of recognition for cost of borrowing and the applicable

depreciable time of the acquired assets.

Candidates are advised to get acquainted with the provision of International

Financial Reporting Standards (IFRS) and be able to apply them to practical

situations.

Marking Guide

Marks

(a) (i) Criteria 2

Recognition of N1m 2

(ii) Computation of cost of capital

and Depreciation 6

(iii) Computation of depreciation

of furnace 4

Redraft of financial statement 2

16

(b) Ethical issues 2

Courses of action 2

20

SOLUTION 5

(a) i. A defined contribution Plan is a post-employment plan under which

an entity pays fixed contribution into a separate entity (a fund) and

will have no legal or constructive obligation to pay further

contributions if the fund does not hold sufficient assets to pay all

employee benefits relating to employee service in the current and

prior periods.

A defined benefit plan is any post-employment benefit plan other than

a defined contribution plan. This plan uses actuarial technique

(projected unit credit method) to estimate the ultimate cost to the

entity of the benefits that employees have earned in return for their

service in the current and prior periods.

Differences between a defined contribution plan and a defined benefit plan

i. Under a defined contribution plan, there are no actuarial assumptions

to make, while under a defined benefit plan actuarial technique is

relevant;

30

ii. Defined contribution plan does not usually affect statement of

financial position whereas defined benefit plan will always affect both

statement of financial position and statement of profit or loss and

other comprehensive income;

iii. Under a defined contribution plan, the entity is ONLY responsible for

the amount of annual contribution payable into the fund, whereas in a

defined benefit plan the amount of benefits receivable by the

employees is key;

iv. Under a defined contribution plan, the obligation is determined by the

amount paid into the plan in each period whereas under a defined

benefit plan, actuarial technique is used to estimate the ultimate cost

to the entity of the benefits that employees have earned in return for

their service in the current and prior periods;

v. In defined contribution plan, amount received by the employee is not

pre-determined while under defined benefit plan, the amount

received by employee is pre-determined;

vi. In contribution plan, the entity is not required to make good any short

falls if pension doesn‟t have enough assets to pay whereas under

benefit plan the entity i.e. employer bears the short fall if the pension

funds are insufficient to pay the retirement of the employees;

vii. In contribution plan the employees bear the risk while in benefit plan

the employer bears the risk; and

viii. No actuarial assumption to make in contribution plan while actuarial

technique is relevant in defined benefit plan.

(b) i. Accounting treatment for Pension Plan I: The accounting for the

defined benefit plan is as follows:

Financial position as at October 31, 2017

31/10/2017 1/11/2016

N‟m N‟m

Present value of obligation 240 200

Fair value of plan assets (225) (190)

15 10

31

Expense in statement of Profit or Loss for year ended 31/10/17

N‟m N‟m

Current service cost 20.0

Net interest expense:

Interest expense – 5% x N200m 10

Interest earned – 5% x N190m (9.5) 0.5

Total expenses 20.5

Computation of Actual Gain or Loss

Actuarial Loss on Obligation (Working 1)

N‟M

Present value of obligation 1/11/16 200

Interest expense (5% x N200m) 10

Current service cost 20

Benefits paid out (19)

211

Present value of obligation 31/10/17 (240)

Actuarial loss of obligation (29)

Actuarial Gain on Plan Assets (Working 2)

N‟M

Fair value on plan assets 1/11/16 190.0

Interest earned (5% x N190m) 9.5

Contribution paid 17.0

Benefit paid out (19.0)

197.5

Fair value of plan assets 31/10/17 225.0

Actuarial Gain on Plan Assets 27.5

Analysis of amount in statement of Other Comprehensive Income (OCI)

N‟M

Actuarial loss on obligation (working 1) 29.0

Actuarial Gain on plan assets (working 2) 27,5

Actuarial Loss on obligation (Net) 1.5

32

Working 3

Movement in net liability in statement of financial position as

31/10/17

N‟M

Opening liability 10.0

Expenses 20.5

Contributions paid (17.0)

Actuarial loss (Net) 1.5

Closing liability 15

`

Accounting Treatment for Pension Plan 2

The accounting for a defined contribution plan is fairly simple because the

employer‟s obligation for each period is determined by the amount that had

to be contributed to the plan for that period.

The company does not recognise any assets or liabilities for the defined

contribution scheme, but charges the contribution payable for the period

(N10m) to operating profit. The contributions paid for the employees will be

part of the wages and salaries cost and when paid will reduce cash.

Tinubun Plc

Statement of contribution paid

N‟m

Contribution paid by employer 10

Contribution paid by employees 10

20

Statement of Profit or Loss

Expenses: N‟m

Contribution paid by employer 10

EXAMINER‟S REPORT

This question tests the understanding of the concept of IAS 19, its interpretation

and practical applications.

About 46% of the candidates attempted the questions and the performance was

below average. Many of the candidates who attempted the question mis-

understood the requirements.

33

The major pitfall encountered by the candidates was wrong interpretation and

application of the concept of IAS 19 especially on the difference between a defined

contribution plan and a defined benefit plan.

Candidates are advised to study and understand the requirement of IFRS in depth

for application at this level of examination. They are to use the ICAN study texts

for better performance in future examinations.

Marking guide

Marks Marks

* Explanation of the Nature of a defined

contribution plan and a defined benefits

plan

3

* Any 4 differences between Pension Plan I

and II (i.e. contribution plan and benefit

plan)

4

7

* Financial position as at 31/10/17 for

Pension Plan I

1

* Statement of Profit or Loss for year ended

31/10/17

1

* Computation of Actuarial loss on

obligation

¾

* Computation of Actuarial gain on Plan

Assets

¾

* Statements of other comprehensive

income

1

* Movement in Net Liability in statements of

financial position (workings)

1

* Explanation of Accounting Treatment for

Pension Plan 2

1

* Statements of contribution paid – Pension

Plan I

1

* Statements of Profit/Loss – Pension Plan II ½ 8

Total 15

34

SOLUTION 6

EKO EXPORTS LIMITED (EEL)

i. The debt owed by the customer existed at the reporting date, but the

customer‟s inability to pay did not exist at that point. This condition only

arose on February 10, 2017. (IAS 10 - Events occurring after the reporting

date)

Thus, this a non-adjusting event

However, for its materiality to the financial statements, the following

disclosure should be made:

Nature of the event

i.e. a description of the fire incident on the customer warehouse and

its subsequent declaration as a bankrupt.

An estimate of its financial effect

Since 50% is recoverable from insurance, the balance of 50% i.e.

N500,000 should be disclosed as the effect of the incident by way of

note.

ii. The amount withdrawn before the year-end i.e. N1.5million is an adjusting

event, though it was discovered after year-end, it existed at year-end. (IAS

10 – Events occurring after the reporting date).

Since 60% has been recovered (N1.5m x 60% - N0.9m) therefore only N0.6m

would be provided in the financial statements.

The further withdrawal of N6.0million is a non-adjusting event, as it

occurred after the year-end.

For its materiality the following should be disclosed by way of note.

Nature of event (i.e. the employee fraud)

The gross amount of contingency (i.e. N6.0million)

The amount recovered subsequently (i.e. N6.0m x 60% = N3.6m)

iii. EEL should not recognise the contingent gain until it is realised (A

contingent asset). (IAS 37- Provisions contingent liabilities and contingent

Assets)

If recovery of damages is probable and material to the financial statements,

EEL should disclose the following in the notes:

35

Brief description of the nature of the contingency asset (i.e.

description of suit for claim of damages again a vendor for supply of

defective goods).

An estimate of the financial effect: (N1million the probable claim).

iv. EEL should make a provision of the expected amount i.e. N1.2million (N1.0m

x 60% + N1.5m x 40%) (IAS 37- Provisions contingent liabilities and

contingent Assets) because

- It is a present obligation as a result of past event;

- It is probable that an outflow of resources embodying economic benefits

will be required to settle the obligation; and

- A reliable estimate can be made of the amount.

In addition, EEL should disclose the following in the notes to the financial

statements:

- Brief nature of the contingent liability (claim against EEL for infringement

of patent);

- The amount of contingency (I.e. N1.2million); and

- An indication of uncertainties relating to the amount or timing of any out

flows.

EXAMINER‟S REPORT

This question tests the application of relevant provisions of standards to a given

scenario, in a real life situation where a qualified professional is expected to handle

on the job.

About 58% of the candidates attempted the question and their performance was

very poor as they were not able to apply the provisions of the standards to the

requirements of the question.

Commonest pitfall of the candidates was inability to interpret the question as

practical application of the standards. Theoretical answers were provided by

majority of the candidates.

Candidates are advised to familiarise themselves with the provisions of the

standards, study the financial reports of organisations for more knowledge to

perform better in future examinations.

36

Marking guide Marks Marks

i. Scenario i

Identification of non adjusting events 1

Nature of the event 1

Estimate of financial effect 1

Identification IAS 10 as the required standard 1 4

ii. Scenario ii

Identification of N9 million as an adjusting event 1

Calculation of amount of provisions 1

Identification of N6m as non-adjusting event 1

Any one of materiality disclosure 1 4

iii Scenario iii

Identification of Contingent asset 1

Two disclosures materiality 2 3

iv Scenario iv

Calculation of correct amount for provisions 1

Disclosures in the financial statements(any three

disclosures)

3

4

Total 15

SOLUTION 7

(a) The Directors,

Mugono Plc

Dear Sir,

Component Reports included in Annual Report

In response to your request on the above subject, below is our report:

Mandatory disclosure reports:

1. A statement of financial position as at the end of the financial period.

2. A statement of comprehensive income for the period (made up of a

statement of profit or loss and other comprehensive income).

3. A statement of changes in equity for the period.

4. A statement of cash flows.

5. Notes to the financial statement, consisting of a summary of significant

accounting policies and other explanatory notes.

37

6. Directors‟ report

7. Independent Auditors‟ report.

Voluntary disclosure reports

8. Audit Committee report.

9. Corporate social responsibility report.

10. Brief description of the business activities in the financial year.

11. Chairman‟s report.

12. Corporate Governance report.

13. Sustainability/Environmental report.

14. Financial summary

(b) i. Three advantages of mandatory disclosures include:

- The statements provide information that are of interest to users

and other stakeholders;

- The mandatory statements shows the financial position as at

the end of a reporting period;

- Mandatory reports shows the financial performance for a

particular period;

- It improves communication to stakeholders;

- It improves public image of the company; and

- Decision making of the stakeholders is improved with

mandatory disclosures.

ii. Advantages of Voluntary Disclosures are as follows:

- It protects the company against any litigation of concealment;

- It provides the potential investors detailed information that will

assist them in appraising the viability of the proposed

investment;

- It improves the fluidity of capital market towards an efficient

capital allocation, thereby bringing down the average cost;

- It provides the public with more robust view and perception of

the company future performance;

- It motivates for better performance;

- It reinforces company‟s communication to shareholders;

- It protects the entity‟s goodwill and reputation; and

- It is a means of passing across the performance level of an

entity‟s corporate social responsibility.

38

iii. Limitations of information provided on a voluntary basis are as

follows:

- The entity can decide on what to include in the report and what

to leave out;

- The information is often presented in a very positive form, as

public relations for investors, and might not be entirely

reliable;

- It increases public expectation regarding future disclosure;

- It increases the involvement of shareholders and might lead to

unnecessary conflicts; and

- The information can be false if not controlled.

We are of the opinion that the above meets your request. However, do not hesitate

to get in touch with the undersigned for clarification, if necessary.

Yours faithfully,

Financial Consultant

EXAMINER‟S REPORT

The question tests candidates‟ knowledge of the components of annual reports with

special attention on the mandatory and voluntary disclosures requirements.

About 96% of the candidates attempted the question and their performance was

above average. However, only about 50% of the candidates who attempted the

questions were able to score above 50% of the allocated marks.

The commonest pitfall is the inability of the candidates to correctly state the

advantages of mandatory and voluntary disclosures.

Candidates are advised to have a better understanding of all the components of

Annual Report and the Mandatory disclosures. The art of report writing should also

be improved upon for better performance in future examinations.

39

Marking guide Marks

(a) Any correct FOUR Components of Annual Report 4

(b) i. Three advantages of mandatory disclosures 3

ii. Four advantages of voluntary disclosures 4

iv. Two limitations of voluntary disclosures 2

Presentation 2

15

40


PROFESSIONAL LEVEL EXAMINATION - NOVEMBER 2017

ADVANCED TAXATION

Time Allowed: 3¼ hours (including 15 minutes reading time)




QUESTION 1

HUSNA Nigeria Limited was incorporated on May 13, 2015 to manufacture

Adhesives using gum arabic. The company is a brainchild of Mr. Onyeocha Ben,

who returned to Nigeria after about 30 years in the United Kingdom. During his

stay abroad, he worked in a similar organisation for over 20 years.

However, on returning to Nigeria in 2009, he has been thinking of how to start a

business that he hopes will outlive him. During various interactions, he was

informed of the wide market for adhesives manufactured with gum arabic. He was

also informed that the company could benefit from the provisions of the Industrial

Development (Income Tax Relief) Act Cap 17, LFN 2004. The company is engaged in

production, even though the Managing Director is yet to understand the tax

benefits derivable from this activity. Nevertheless, the company applied for and

was granted a Pioneer Certificate with Production Day certified as July 1, 2015.

The company‟s financial records contained the following information:

N

(i) Accumulated profit as at June 30, 2016 41,250,000

(ii) Capital expenditure incurred during Pioneer period

as certified by the FIRS:

Building 20,000,000

Property, Plant and Equipment 18,750,000

Motor vehicles 12,500,000

Furniture and Fittings 6,250,000

(iii) After the end of the pioneer period, the company adopted December 31, as

its year end and the adjusted profits from the new trade were:

N

6 months to December 31, 2016 15,000,000

Year to December 31, 2017 22,500,000

41

As a tax consultant, you are REQUIRED to:

a. Explain briefly the conditions for granting a Pioneer Status to a company.

(4 Marks)

b. Compute the tax liabilities of the company for the relevant years of

assessment. (18 Marks)

c. Differentiate between Tax Audit and Tax Investigation. (8 Marks)

(Total 30 Marks)



QUESTION 2

Skkye Petroleum Plc. commenced operations over ten years ago and its accounting

date is December 31, annually.

The following details have been extracted from the accounting records for the year

ended December 31, 2016:

(i) Crude Oil exported - 3,500,000 barrels

(ii) Crude oil used locally - 1,200,000 barrels at N100 per barrel

N

(iii) Incidental income from petroleum operations - 26,750,000

(iv) Exploration and drilling costs - 30,000,000

(v) Management and Administration expenses - 240,500,000

(vi) Non – Productive rents - 8,300,000

(vii) Provision for bad debts - General

- Specific

-

-

7,500,000

11,200,000

(viii) Depreciation - 7,250,000

(ix) Losses brought forward - 13,200,000

(x)

Qualifying Capital Expenditures are as follows:

- Pipeline and Storage Tanks acquired in March 2016,

located in the Continental Shelf of 190 meters water

depth.

- Plant and Machinery acquired in June 2014, located in

territorial waters of 90 metres water depth.

- Furniture and Fittings acquired in May 2013, located in

territorial waters of 95 metres water depth

- Buildings erected in April 2015, located onshore.

N„000

48,000

63,800

21,000

71,000

42

You were able to confirm that Management and Administration

expenses comprise the following:

N„000

Donations to XYZ Political Party 8,500

(ii) Expenditure relating to the purchase of information relating

to the existence and extent of petroleum deposits

4,700

(iii) Companies Income Tax of an associated company 5,000

(iv) Interest on inter-company loans obtained under terms

prevailing in the open market

2,600

(v) Staff salaries 175,000

(vi) Royalties on export sales 6,200

(vii) Repairs and renewals incurred on Property, Plant and

Equipment for the purpose of carrying on Petroleum

operations

2,900

(viii) Rents paid in respect of land and buildings occupied under

an Oil Prospecting Licence

3,600

(ix) Other administrative expenses 32,000

240,500

The International Market Price of Crude Oil in 2016 was USD $75 per barrel and the

exchange rate was USD $1:N280.

You are required to compute the:

a. Assessable Profit (11 Marks)

b. Chargeable Profit (51

/2 Marks)

c. Assessable Tax (1 Mark)

d. Chargeable Tax (11

/2 Marks)

e. Tertiary Education Tax (1 Mark)

(Total 20 Marks)

43

QUESTION 3

a. Outline FIVE objectives of the Memorandum of Understanding which the

Federal Government of Nigeria entered into with the Oil Producing Companies

on January 1, 1986. (5 Marks)

b. SALIM CONSULTANTS LIMITED, which was incorporated in 2012, is a firm of

corporate advisors resident in Nigeria. In 2015, it expanded to Burundi to tap

into the booming business opportunities in that country.

The directors have heard of Double Taxation Agreement with the attendant

benefits, even though the company has never been a beneficiary. The

directors, being highly educated executives, have tried on their own to read

about and understand the concept of Double Taxation Agreement and the

attendant reliefs, all to no avail.

Below is a summary of the Income Statements for the year ended December

31, 2016:

Nigeria Burundi Total

N N N

Gross Advisory fees 57,000,000 21,750,000 78,750,000

Other Income 960,000 1,800,000 2,760,000

57,960,000 23,550,000 81,510,000

Deduct Expenses:

Deal Execution Expenses (30,225,000) (9,750,000) (39,975,000)

Office Rent (1,800,000) (675,000) (2,475,000)

Depreciation (5,100,000) (2,700,000) (7,800,000)

Loss on sale of Non- Current Assets - (525,000) (525,000)

Foreign Exchange Loss Provision (960,000) - (960,000)

Other Operating Expenses (3,240,000) (1,380,000) (4,620,000)

Net Operating Profit 16,635,000 8,520,000 25,155,000

Additional information:

(i) The sum of N2,130,000 was paid to the Burundi Tax Authority for the

year, after claiming N4.800,000 Capital Allowance. Capital Allowance

claimable in Nigeria was N7,800,000.

(ii) Other income of N960,000 is profit from sale of Non-Current Assets, while

N1,800,000 is gains from disposal of securities.

Required:

As a Tax Practitioner:-

a. Explain briefly what is meant by Double Taxation Relief. (3 Marks)

b. Compute the Double Tax Credit claimable by the Company assuming there

is a Double Taxation Agreement with Burundi. (12 Marks)

(Total 20 Marks)

44

QUESTION 4

Mr. Afolabi owns Afolabi Mining Limited, a company based in Itakpe. The company

has been in the mining business since 1999. The company has been facing

financial problems in recent times. Based on advice, the directors bought a

pulverising equipment on hire purchase on January 1, 2013 and paid the sum of

N49,875,000 as a deposit on the cash purchase price of N78,750.000.

Afolabi Mining Limited was allowed to pay the balance in twenty monthly

instalments of N1,750,000 each, with effect from February 1, 2013.

As the Tax Consultant of the company, you are REQUIRED to:

a. Compute the Capital Gains Tax payable for the relevant Years of Assessment,

assuming that the equipment was sold for:

i. N84,700,000 after the payment of instalments on November 3, 2013

payment. (5 Marks)

ii. N86,800,000 after the payment of instalments on August 5, 2014.

(5 Marks)

b. Outline the allowable and disallowable deductions in computing Capital

Gains Tax. (6 Marks)

c. Explain „Year of Assessment‟ in the context of the Capital Gains Tax Act CAP

C1 LFN 2004. (2 Marks)

d. Explain the term „Connected Persons‟. (2 Marks)

(Total 20 Marks)

SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THE THREE

QUESTIONS IN THIS SECTION (30 MARKS)

QUESTION 5

PAPA EJIMA LIMITED has been in the business of manufacturing for both export

and local sales. The company filed tax returns for 2014 Assessment Year.

Upon desk examination, the Federal Inland Revenue Service (FIRS), wrote the

company to pay additional Value Added Tax (VAT) and Withholding Tax (WHT)

amounting to N360,000 and N3,050,000 respectively.

Upon receipt of this letter, the Managing Director was angry, claiming that the

company‟s returns were accurate.

The records of the company for the Accounting Year ended December 31, 2013

showed:

45

N

Revenue 187,500.000

Cost of sales (102,500,000)

Gross Profit 85,000,000

Other income 31,250,000

Operating expenses (57,250,000)

Interest and similar charges (3,200,000)

Profit before tax 55,800,000

Taxation (6,250,000)

Profit after tax 49,550,000

Dividend (38,500,000)

Retained profit for the year 11,050,000

Other relevant information includes:

(i) Revenue was made up of: N

- Export sales 58,500,000

- Local sales 129,000,000

N

(ii) Cost of sales comprises of:

- Opening inventory (VAT inclusive) 22,800,000

- Closing stock (VAT inclusive) 37,150,000

- Purchase of raw material 90,600,000

- Freight charges 18,700,000

- Other direct materials 27,550,000

(iii) Other income includes: N

- Foreign exchange gain 4,800,000

- Profit on sale of Non-current assets

(sales proceeds is N21.5m) 8,850,000

- Management fees from subsidiary

companies 17,600,000

(iv) Operating expenses are made up of:

- Office rent 18,000,000

- Audit fees 4,000,000

- Consultancy fees to ZXY Ltd 11,000,000

- Directors‟ fees 7,500,000

- Other expenses 16,750,000

(v) The company purchased Non-Current Assets (VAT inclusive) 84,000,000

(vi) VAT remitted to FIRS during the year 1,976,235

(vii) WHT remitted to FIRS during the year 6,650,000

46

As the tax consultant of the company, you have seen the Firs assessment serve on

your client on April 5, 2016.

Required:

Advise the Company on the Objection and Appeal procedures in a memo to the

Managing Director. (Total 15 Marks)

QUESTION 6

Pategi and Abu are brothers based in Hakketstown in New Jersey, United States of

America. In 2009, the two brothers and ten other African-Americans incorporated a

Company, Pategi Telecommunications Limited whose major line of business is

telecommunications. The company has a representative office in Share, Kwara

State, Nigeria. In the year ended December 31, 2014, the following transactions

were extracted from the books of accounts of the company:

(i) Number of minutes of Telecommunication transactions:

minutes

U.S. to other parts of the World 1,705,000

U.S. to Nigeria 374,000

Nigeria to U.S. 426,250

Nigeria to Canada 550,000

U.S. to Canada through Nigeria 794,750

3,850,000

(ii) The world-wide expenses incurred include the following:

N

Refurbishment 7,150,000

Rent 1,100,000

Depreciation 25,991,563

Salaries and Wages 4,065,188

Other disallowable expenses 9,658,000

Administrative expenses 4,820,750

52,785,501

(iii) The average charge for messages applicable during the year under review is

$0.50 per minute. The applicable rate of exchange is N198 to $1.00.

Required:

Advise the company on the total tax liabilities for the relevant year of

assessment. (Total 15 Marks)

47

QUESTION 7

The prevailing economic condition in the Country has led to the business cessation

of many Small and Medium Scale Enterprises (SMEs).

ABA FOODS LIMITED, based in Abia State, is a popular company known for

producing high quality foods and beverages. However, due to unwillingness of

banks to lend on a long-term basis, the company could not replace its ageing and

obsolete property, plant and equipment which led to a trajectory of losses. The

directors of the company and the elders of the community, where the factory is

sited, pray that their products with household name of “choice” should continue to

be popular, given the acceptability of these products in the market.

In the alternative, the directors went in search of prospective investors who might

be interested in either a merger or total acquisition.

They finally initiated discussions with Chief Egodi, a prominent businessman with a

vast business empire known as Ifedi Group of companies. One of the companies in

the group is Ifedi Foods and Beverage Limited which produces similar products to

Abia Foods Limited.

Chief Egodi who is quick-witted, understands from experience in running his other

companies that such business dealings will naturally attract the attention of the

Federal Inland Revenue Service (FIRS) but he is unsure of the tax implications of

which of the options he chooses.

Consequently, he approached his solicitors for advice, who in turn recommended

your firm, ALIYARA & Co. Chartered Accountants, for professional advice.

You are required to make a presentation in the form of Advice:-

a. Explaining the tax implications of Aba Foods Limited merging with Ifedi

Foods and Beverage Limited, where the latter inherits all the assets and

liabilities of the merging companies. (5 Marks)

b. Explaining the tax implications, if Ifedi Foods and Beverage Limited is re-

constituted to take over the assets and liabilities of Aba Foods Limited.

(5 Marks)

c. Explaining the tax implications, if Ifedi Foods and Beverage Limited and Aba

Foods enter into a Joint Venture Agreement or Partnership.

(5 Marks)

(Total 15 Marks)

48

NIGERIAN TAX RATES

1. CAPITAL ALLOWANCES

Initial % Annual %

Office Equipment 50 25

Motor Vehicles 50 25

Office Buildings 15 10

Furniture and Fittings 25 20

Industrial Buildings 15 10

Non-Industrial Buildings 15 10

- Agricultural Production 95 Nil

Plant and Machinery - Others 50 25

2. INVESTMENT ALLOWANCE 10%

3. RATES OF PERSONAL INCOME TAX

Consolidated relief allowance is computed at N200,000 or 1% of Gross Income

whichever is higher + 20% of Gross Income.

After the Consolidated relief allowance and tax exempt items have been

granted, the balance of income shall be taxed as specified in the tax table

below:

Taxable Income

(N)

Rate of Tax

(%)

First 300,000 7

Next 300,000 11

Next 500,000 15

Next 500,000 19

Next 1,600,000 21

Over 3,200,000 24

4. COMPANIES INCOME TAX RATE 30% of Total Profit

5. TERTIARY EDUCATION TAX (2% of Assessable Profit)

6. CAPITAL GAINS TAX 10%

7. VALUE ADDED TAX 5%

49

SOLUTION 1

(a) Conditions for granting Pioneer Status to any Company

The National Council of Ministers (the Council) may declare an industry a

pioneer industry and products of the industry pioneer products if it is

satisfied that;

i. The industry is not being carried on in Nigeria at all; or

ii. The industry is being carried on in Nigeria on a scale which is not

suitable to the economic requirements of Nigeria; or

iii. There are favourable prospects of further development in Nigeria of

any industry; or

iv. It is expedient in the public interest to encourage the development or

establishment of any industry in Nigeria.

(b) HUSNA NIGERIA LIMITED

COMPUTATION OF TAX LIABILITIES

FOR 2015 TO 2017 ASSESSMENT YEARS

N N

2015 Assessment Year

Basis period (1/7/2015 – 31/12/2015)

Assessable profit 15,000,000

Capital allowances:

Capital allowances for the year (wk1) 25,334,375

Relieved (15,000,000) (15,000,000)

Unrelieved capital allowances c/f 10,334,375

Total profit NIL

Companies Income Tax – 30% of total profit NIL

Tertiary Education Tax – 2% of Assessable profit

(2% of N15,000,000) 300,000

50


Basis period (1/7/2015 – 30/6/2016)

N N

Assessable profit (N15,000,000 + 6

/12

x N22,500,000) 26,250,000

Capital allowances:

Unrelieved b/f (10,334,375)

Capital allowances for the year (wk 1) (6,543,750)

(16,878,125)

Relieved (16,878,125) (16,878,125)

Unrelieved capital allowances c/f -

Total Profit 9,371,875

Companies Income Tax – (30% x N9,371,875) 2,811,562.50

Tertiary Education Tax – (2% x N26,250,000) 525,000

Assessable profit ÷ Profit of 6 months to 31 December, 2016 plus

6/12 of profit to December 31, 2017


Basis period (1/1/2016 – 31/12/2016)

N

Assessable profit 22,500,000

Capital allowances:

Unrelieved b/f -

Capital allowances for the year (wk1) 6,543,750

Relieved (6,543,750) (6,543,750)

Unrelieved capital allowances c/f -

Total Profit 15,956,250

Companies Income Tax – (30% x N15,956,250) 4,786,875

Tertiary Education Tax – (2% x N22,500,000) 450,000

NB Company Income Tax is 30% of Total Profit.

Tertiary Education is 2% of Assessable Profit.

51

Workings

HUSNA NIGERIA LIMITED

Computation of Capital Allowances

For 2015 to 2017 Assessment Years

Building Property,

Plant &

Equipment

Motor

Vehicles

Furniture &

Fittings

Total

Allowances

Investment

allowance

Initial

allowance

Annual

allowance

-

15%

10%

10%

50%

25%

-

50%

25%

-

25%

20%

N N N N N

2015 YOA

(1/7/2015-

31/12/2015

Qualifying

expenditure at

1/7/2015

20,000,000

18,750,000

12,500,000

6,250,000

Investment

allowance

-

(1,875,000)

-

-

1,875,000

Initial

allowance

(3,000,000)

(9,375,000)

(6,250,000)

(1,562,500)

20,187,500

Annual

allowance

(6 months)

(850,000)

(1,171,875)

(781,250)

(468,750)

3,271,875

WDV 16,150,000 8,203,125 5,468,750 4,218,750 25,334,375

2016 YOA

(1/7/2015-

30/6/2016)

Annual

allowance

(1,700,000)

(2,343,750)

(1,562,500)

(937,500)

6,543,750

WDV 14,450,000 5,859,375 3,906,250 3,281,250

2017 YOA

(1/1/2016-

31/12/2016)

Annual

allowance

(1,700,000)

(2,343,750)

(1,562,500)

(937,500)

6,543,750

WDV C/F 12,750,000 3,515,625 2,343,750 2,343,750

52

Notes:

i. Capital allowances are not granted during the pioneer period; they

are granted with effect from 1 July 2015 after the expiration of the

pioneer period.

ii. Husna Nigeria Limited is a manufacturing company, hence the capital

allowances claimable in a year are not restricted.

iii. The pioneer period covers 3 years (i.e. 1/7/2012 to 30/6/2015).

Consequently, the accumulated profits of N41,250,000 are exempted

from tax.

iv. Investment allowance of 10% is granted on qualifying expenditure on

property, plant and equipment. However, it is not deductible from the

cost of the asset to arrive at the written down value of the asset as is

the case with initial and annual allowances.

(c) Tax Audit

Tax Audit is an exercise carried out by tax officials from relevant tax

authority (ies). The exercise is essentially meant to enable the tax authority

to further satisfy itself that the audited Financial Statements and related tax

computations submitted by the taxpayer agrees with the underlying records.

This periodic check is usually undertaken by the Tax Audit Branch. There are

two types of Tax Audit:

(i) Desk Audit – This is the audit carried out in the tax office by an

inspector, on the tax returns submitted to the tax office.

(ii) Field Audit – This is usually a more elaborate and comprehensive

exercise than a Desk Audit. It is usually carried out in the taxpayer‟s

business premises.

Tax Investigation

This is an enquiry usually carried out on a company in order to ascertain any

unpaid taxes by the company, resulting from any action by the company

deliberate or otherwise – leading to an under-assessment of the company.

Tax investigations are distinct from tax audits. – The former arises when a

taxpayers is suspected to have committed fraud in the form of tax evasion-of

tax liability arising from:

53

- Failure to file tax returns;

- Filing of incomplete or inaccurate returns; and

- Failure to register for tax purposes, etc

The principal objective of a tax investigation is to expose all the

circumstances of the fraud or tax evasion and to obtain evidence for possible

prosecution for the recovery of back taxes from the taxpayer.

Other distinguishing factors are:

i. Scope

In Tax Audit, the scope of work is limited to the underlying records

and it is less involving, while in tax investigation, the scope of work is

wider than that of tax audit. The details of checking and the depth of

work are beyond what is required in Tax Audit and a sub-set of tax

investigation.

ii. Objectives

Tax Audit

The primary objectives of tax audit are to ensure that a taxpayer is tax

compliant and pays appropriate amount of tax which agrees with the

financial records of the taxpayers. Other secondary objectives of tax

audit include discouragement of tax evasion.

Tax investigation

The objective of tax investigation is to discover and expose all

circumstances of the matter being investigated.

iii. Legal Requirements

Tax Audit

Section 4 (34) of CITA Cap C21 LFN 2004 was introduced to empower

the relevant tax authority to conduct tax audit. Tax audit legally

requires a taxpayer to periodically confirm the accuracy of the self-

assessment.

Tax investigation

This may not be required for some Tax payers for several years. Tax

investigation is usually done after a tax audit.

iv. Outcome

Tax audit

This may result in additional assessment or referral for tax

investigation in case Tax evasion is suspected.

54

Tax investigation

This may result in criminal prosecution, especially where there is a strong evidence

against the taxpayer, otherwise the investigation is terminated if evidence is weak.

EXAMINER‟S REPORT

This question tests candidates knowledge on conditions precedent on pioneer

status.

Performance was above average.

The major pitfall was the inability of candidates to understand pioneer provision

and differences between tax audit and tax investigation.

Candidates are advised to be more elaborate in their preparations for future

examinations by making use of ICAN Study Texts and Pathfinder.

Marking Guide

Marks Total

Marks

(a) Conditions for granting Pioneer Status

I mark for any four points (1 x 4) 4

(b)

Computation of tax liabilities

- - Heading 1

- - 2015 YOA stated ½

- - Assessable profit ½

- - C/A for the year ½

- - C/A claimed ½

- - Unrelieved C/A ½

- - Total profit ½

- - Companies Income Tax (CIT) ½

- - Tertiary Education Tax (TET) ½ 5

ii. 2016 YOA ½

- Assessable profit ½

- Unrelieved b/f ½

- C/A for the year ½

- C/A claim ½

- Total profit ½

- CIT ½

- TET ½ 4

55

iii. 2017 YOA ½

- Assessable profit ½

- Unclaimed b/f ½

- C/A for the year ½

- C/A claimed ½

- Total profit ½

- CIT ½

- TET ½ 4

iv Computation of Capital allowances for

the relevant years of assessment

2015 - Investment allowance 1

- Initial allowance 1

- Annual allowance 1

2016 - Annual allowance 1

2017 - Annual allowance 1 5

22

(c) Difference between Tax Audit and Tax

Investigation

2 marks for each of any four points 8 8

30

SOLUTION 2

SKKYE PETROLEUM PLC

COMPUTATION OF PETROLEUM PROFITS TAX

FOR 2014 ASSESSMENT YEAR

N‟000 N‟000

Crude oil exported (3,500,000 x 75 x N280) 73,500,000

Local sale of crude oil (1,200,000 x N100) 120,000

Incidental income from petroleum operation 26,750

Total income 73,646,750

Allowable Expenses:

Exploration and drilling costs 30,000

Interest on inter-company loans obtained under terms

prevailing in the open market

2,600

Staff salaries 175,000

Royalties on export sales 6,200

Repairs and renewals 2,900

Rents paid 3,600

Other administrative expenses 32,000

Non-productive rents 8,300

Specific provision for bad debts 11,200 (271,800)

Adjusted Profit 73,374,950

(13,200)

56

Losses brought forward

Profit before Tertiary Education Tax 73,361,750

Deduct: Tertiary Education Tax (2/102 x N73,361,750,000) 1,438,466

(a) Assessable profit 71,923,284

Deduct: Capital allowance:

Capital allowance for the year 40,760

Petroleum Investment Allowance (see workings) 7,200

47,960

Restricted to:

85% Assessable profit (85% x N71,923,284) 61,134,791

Less: 170% of Petroleum Investment Allowance (12,240)

61,122,551

Capital allowance claimed (47.960)

(b) Chargeable profit 71,875,324

(c) Assessable Tax (85% of Chargeable Profit)

61,094,025

Less: Section 20 deductions -

(d) Chargeable Tax 61,094,025

(e) Tertiary Education Tax (2% of Assessable Profit) 1,438,466

Note:

There is no indication in the question that this company operates under the Deep

Offshore and Inland Basin Production Sharing Contracts, hence no Section 20

deductions are applicable.

Workings

Computation of Capital Allowances and Petroleum Investment Allowance

Assets Year of

Acquisition

Cost Rate Capital

Allowance

Investment

Allowance

between

100m to

200m @

15%

N‟000 N‟000 N‟000

Pipeline and storage

tanks

2014 48,000 20% 9,600 7,200

Plant & Machinery 2012 63,800 20% 12,760 -

Furniture & Fixtures 2012 21,000 20% 4,200 -

Buildings 2013 71,000 20% 14,200 -

203,800 40,760 7,200

57

EXAMINER‟S REPORT

This question test candidates knowledge on Petroleum Profits Tax.

Majority of the student attempted the question and performance was average.

Major pitfall was the inability to calculate the offsets.

Candidates are advised to make use of the Institute‟s Study Texts and Pathfinder.

Marking Guide

Marks

Heading of solution 1

Derivation of Total Income 3

Allowable expenses (1

/2 mark each for 9 expenses) 4½

Losses brought forward ½

Tertiary Education Tax ½

Assessable profit ½

Total Capital Allowances for the year ½

Petroleum Investment Allowance ½

Restriction of 85% of Assessable Profit ½

170% of Petroleum Investment Allowance ½

Capital Allowance claimed ½

Chargeable profit ½

Assessable Tax 1

Section 20 deduction ½

Chargeable Tax 1

Tertiary Education Tax 1

Capital allowance computed for each asset (1

/2 mark per asset for 4

assets)

2

Computation of Investment Allowance ½

20

58

SOLUTION 3

(a) Objectives of the Memorandum of Understanding (MOU)

i. Enhancing crude oil exports.

ii. Encouraging investments in exploration and development activities.

iii. Encouraging investments in the area of enhanced oil recovery

projects.

iv. Encouraging investments in gas utilisation projects.

v. Encouraging increased lifting and sale of NNPC‟s equity crude.

vi. Effectively reducing the tax impact on companies engaging in

petroleum operations.

vii. MOU is a tool for encouraging, maintaining and enforcing cost

Efficiency.

(b)

i) Double taxation relief is a relief or credit available in the Nigeria tax law on

income that has suffered foreign tax outside Nigeria. The objective is to

ensure as much as possible that incomes liable to tax in Nigeria do not suffer

tax twice.

The relief or credit claimable depends on whether Nigeria has a Double

Taxation Agreement (DTA) with the country from which the foreign income

was derived or not.

ii)

SALIM CONSULTANTS LIMITED

COMPUTATION OF DOUBLE TAXATION RELIEF CLAIMABLE


Nigeria Burundi Total

x X X

Net operating profit 16,635,000 8,520,000 25,155,000

Add back:

Depreciation 5,100,000 2,700,000 7,800,000

Loss – sale of non-current assets - 525,000 525,000

Exchange loss provision 960,000 - 960,000

22,695,000 11,745,000 34,440,000

Profit on sale of non-current assets (960,000) - (960,000)

Gain on sale of securities - (1,800,000) (1,800,000)

Adjusted profit 21,735,000 9,945,000 31,680,000

Less Capital Allowance (7,800,000) (4,800,000) (12,600,000)

Total profits 13,935,000 5,145,000 19,080,000

59

SALIM CONSULTANS LIMITED

COMPUTATION OF DOUBLE TAXATION RELIEF CLAIMABLE

2017 YEAR OF ASSESSMENT

(a) Assuming there is Double Taxation Agreement

Nigerian Tax Payable on Burundi Operation: N

30% of N5,145,000 = 1,543,500

Tax paid to Burundi Tax Authority = 2,130,000

Double Taxation Relief:

Lower of Nigerian Tax and Foreign Tax = 1,543,500

(b) Assuming No Double Taxation Agreement

The lower of

½ NRT = 15% x N5,145,000 = 771,750

And CWRT = 41.40% of N5,145,000 = 2,130,000

Answer Double Taxation Relief = N771,750

Workings: Common Wealth Rate of Tax

Foreign Tax

Foreign Total Profit𝑥

100

1

N 2,130,000

5,145,000𝑥

100

1 = 41.40%

EXAMINER‟S REPORT

This is a question designed to test candidates‟ knowledge and understanding of

both the concept and objectives of the Memorandum of Understanding (Mou)

between the Federal Government and the Oil Producing Companies operating in

Nigeria.

The question also covered the incidence of Double Taxation Agreement and its

attendant benefits by way of Tax Reliefs.

Candidates displayed above-average understanding of Part (a) of the question

which deals with the MOU, but clearly did not understand how to compute related

Reliefs available under the two scenarios. Some candidates also mistakenly

60

computed Tax Liability – instead of the Reliefs claimable by way of Double Tax

Credit claimable by the company.

Total

Marking Guide Marks Marks

(a) Objectives of MOU with Oil producing companies

in JV operations

(1 mark each of any 5 points) 5 5

(b) i. Definition and objective of Double Tax Relief

(DTR)

2

Effect on Double Tax Agreement

(DTA) on relief claimable 1 3

(c)ii. Workings to derive Total Profit for Burundi

operations – 8 figures posted correctly carry ½

mark each

4

4

- Correct heading for computation of relief

claimable under DTA

1

/2

½

Computing Nigerian Tax on Burundi Income 1

Stating tax paid to Burundi Tax Authority ½

Choosing lower of Nigerian Tax and Foreign tax

paid as relief claimable

1½

3

Assume No DTA

-Compute relief at ½ Nigeria Tax rate 1

-Compute relief at Common Wealth Rate of Tax 1

-Choosing lower of the two as Double Taxation

relief claimable

1½

3½

Workings for computation of Common Wealth

Rate of Tax

1

20

61

SOLUTION 4

(a)

AFOLABI MINING LIMITED

COMPUTATION OF CAPITAL GAINS TAX


N N N

Sales proceeds of Equipment 84,700,000

Cost of Equipment

Deposit paid 49,875,000

Instalments paid (10 months @ N1,750,000 each) 17,500,000

Interest portion paid (3,062,500)

14,437,500

(64,312,500)

Chargeable Gains 20,387,500

Capital Gains Tax thereon @ 10% 2,038,750

(b)

AFOLABI MINING LIMITED

COMPUTATION OF CAPITAL GAINS TAX


N N N

Sales proceeds of equipment 86,800,000

Cost of Equipment

Deposit paid 49,875,000

Instalments paid (19 months @ N1,750,000 each) 33,250,000

Interest portion paid (wk3) (5,818,750) 27,431,250

(77,306,250)

Chargeable Gains 9,493,750

Capital Gains Tax thereon @ 10% 949,375

62

(wk 1)

Calculation of Hire Purchase Interest

(wk 2)

Calculation of Hire Purchase Interest up to 1/11/2013;

Hire Purchase Interest payable = N6,125,000

Hire Purchase Interest at the time of Disposal – 3/11/2013

N 6,125,000 x 10 = N3, 062,500

20

(wk 3)

Calculation of Hire Purchase Interest up to 1/9/2014;

Hire Purchase Interest for 19 months at the time of Disposal

(i.e. 5/8/2014) = N6,125,000/20 x 19 months = N5,818,750

(b) Allowable deductions;

i. Cost of acquisition or purchase price, including all costs incidental to

the purchase;

ii. Improvement costs wholly, reasonably, exclusively and necessarily

incurred;

iii. Cost wholly, reasonably, exclusively and necessarily incurred in

establishing, preserving or defending the owner‟s title to or a right over

the asset;

iv. Incidental cost of disposal.

Disallowable deductions;

i. Sums allowable as a deduction in computing the profits or gains or

losses of a trade for income tax purposes are not allowable deductions

ii. Insurance premiums on the asset are not allowable

Hire purchase price: N N

Deposit (1/1/2013) 49,875,000

20 Instalments payable (February 2013 to

September 2014) @ 1,750,000 per month 35,000,000

84,875,000

Cash price (78,750,000)

Hire Purchase Interest for 20 months 6,125,000

63

(c) Year of Assessment

A year of assessment in relation to Capital Gains Tax means, a year

beginning with January 1 and ending with December 31 in the same year.

(d) Connected Persons

Certain persons treated as being so closely involved with each other that

they have to be viewed as the same person or that transactions between

them need to be treated differently from those at arm‟s length.

Transactions between such persons may be regarded as artificial or fictitious

for the purpose of determining the tax liability arising therefrom.

Consequently, the Revenue can make whatever adjustments as it considers

necessary to counteract the reduction of liability to tax that could otherwise

result from such transactions.

EXAMINER‟S REPORT

This question test candidates‟ knowledge of the provisions of Capital Gains Tax Act

CAP C1 LFN 2004. The question is designed to test candidates‟ knowledge and

understanding of the basic principles regarding the allowable and disallowable

deductions as well as the concept of „Connected Persons‟ and the relevant Year of

Assessment in the process of computing Capital Gain Tax. A good number of the

candidates attempted the question and performance was above average.

Some candidates had problems proffering correct solutions to parts (b), (c) and (d)

of the question more specifically they displayed ignorance of the concept of

“Connected Persons”.

Candidates are advised to be more thorough and discerning in their preparations

for future examinations.

Marking Guide Total

Marks Marks

ai Sales proceeds of N84,700,000 1

Deposit paid ½

Instalments paid 1

Interest portion paid 1

Chargeable gains ½

Capital Gains Tax 1 5

ii Sales proceeds of N86,800,000 1

Deposit paid ½

Instalments paid 1

64

Interest portion paid 1

Chargeable gains ½

Capital Gain Tax 1 5

bi Allowable deductions (1 mark each for each of 3

points mentioned)

3

ii Disallowable deductions (11

/2 marks for each point

mentioned)

3

c. Explain „Year of Assessment‟ 2

d. Explain the term „Connected Persons‟ 2 10

20

SOLUTION 5

MEMO

DATE: November 17, 2017

FROM: Managing Partner, Richard Obaloluwa & Co.

TO: The Managing Director, Papa Ejima Limited

RE: OBJECTION AND APPEAL PROCEDURES

The additional assessment issued to a Taxpayer may be objected to. However,

there are laid down procedures to be followed in order to have a valid objection

and a successful appeal. Below is the summary of Objection and Appeal

procedures in practice:

(1) Notice of Objection – If any taxpayer disputes a tax assessment raised on it

by the Tax Authority, it may give a notice of objection to the tax authority

seeking a review of the assessment. The objection must be a valid objection,

However, a valid objection must:

(a) Be in writing and addressed to the Chairman, Federal Inland Revenue

Service;

(b) State the grounds of Objection; and

(c) Be raised within thirty (30) days of the date of service of the notice of

assessment.

(2) On receipt of the Notice of Objection, the Tax Authority has the following

options:

(a) Review and revise the assessment to an amount that is mutually

65

agreeable to both the Taxpayer and the Tax Authority and thereafter

issue Notice of Revised Assessment to the Taxpayer, or

(b) Review and refuse to revise the assessment to the amount, then issue

a Notice of Refusal to Amend the Assessment to the Taxpayer

(3) Appeal to the Tax Appeal Tribunal.

Where the actions in (2) above, do not favour the Company, it has the right

to proceed to the Tax Appeal Tribunal for hearing.

The Tax Appeal Tribunal will give seven (7) days notice to the Appellant and

Tax Authority of the date and place fixed for hearing of the Appeal. An

appeal would be heard by not less than three members of the Tax Tribunal in

attendance with the Chairman or any other member, (in the absence of the

Chairman), presiding.

Any member with vested interest in any matter before the Tax Appeal

Tribunal must disclose such interest and abstain from attending any sitting,

at which the matter is to be heard. All appeals before the Tax Appeal

Tribunal are heard in public and appellant may be represented by a

professional adviser or may give its evidence by written notice;

Appellant leads the case, by proving that the assessment is excessive, that is-

the onus of proof is put on the appellant. However, if the representative of

the Tax Authority can prove to the Tribunal that:

(i) Appellant failed to file Returns, Audited Accounts etc, or

(ii) The appeal is frivolous, vexatious or an abuse of appeal process; or

(iii) It is expedient to require appellant to pay a security deposit:

The Tax Appeal Tribunal may make an order that the appellant pays a

deposit to the Tax Authority on account of the tax being disputed, before the

matter could be heard.

The Tax Appeal Tribunal can confirm, reduce, increase, or annul the

Assessment, as deemed necessary. The Tax Appeal Tribunal‟s decisions are

recorded in writing, by the Chairman, and a Certified True Copy is supplied

to the Appellant or the FIRS on request, within 3 months of the decision.

Particulars of the extent to which the Tax Appeal Tribunal is not satisfied

with the appellant‟s accounts, books, etc, non-compliance with precepts

delivered by the Tax Appeal Tribunal by the appellant or his representative

and refusal to answer questions put, should all be noted in the decision of

the Tax Appeal Tribunal, and Notice of the amount of tax chargeable, as

determined by the Appeal Tribunal, shall be served on the Company by FIRS.

The tax payable as determined by the Tax Appeal Tribunal is payable within

One (1) month of the date of notice of assessment.

66

(4) Further Appeals

The taxpayer may proceed to the Federal High Court if dissatisfied with the

decision of the Tax Appeal Tribunal. For such appeal to be valid, the

following conditions must be satisfied:

(i) Amount involved must not be less than N400;

(ii) The appeal must be on points of law;

(iii) Notice of appeal must be given to the Tax Appeal Tribunal within 30

days after the date of the judgement of the Tax Appeal Tribunal.

(iv) The grounds of law on which the decision of the Tax Appeal Tribunal

is being challenged should be stated.

Further appeal against the decision of the Federal High Court shall lie with

the Court of Appeal and from there to the Supreme Court.

Kindly meditate on the procedures and revert to us, if there is need to

activate the procedure against the additional Assessment or more, preferably

to call for a further discussion with the Tax Authority on the subject.

Yours faithfully,

For: Richard Obaloluwa & Co,

Tax Partner

EXAMINER‟S REPORT

This is a question designed to test candidates‟ knowledge and understanding of the

issues that could generate the need for a Corporate Taxpayer to object to an

Assessment by the Federal Inland Revenue Services (FIRS). It also tested

candidates‟ ability to proffer a comprehensive memo to the Managing Director, on

the Objective and Appeal procedures.

About half of the candidate attempted the question and performance was below

average.

Candidates are advised to be more thorough in identifying the correct requirements

of a question, before proffering solutions in future examinations. They are also

advised to make use of ICAN‟s Study Texts.

67

MARKING GUIDE MARKS TOTAL

MARK

1 Correct addressee ½

2 Subject Introduction

3 Objective and Appeal procedures 4 4

4 Tax Authority Options 2 2

5

6

7

Appeal to the Tax Appeal Tribunal

Tax Appeal Tribunal steps

- Notice to appellant re: date and place for

hearing the appeal

- Minimum members of Tribunal to hear

Appeal

- Member with vested interest must not attend

such hearing

- All appeals are heard in public or made in

writing

- Appellant to prove the Assessment as

excessive

- Appeal Tribunal to make order for appellant

- Appeal Tribunal confirm, reduce, increase or

annual assessment

- Tax payable within one month

Further Appeal to the Federal High court

- Conditions for further appeal

- Further appeal up to Supreme Court

Close of memo, name and signature

1

/2

1

/2

1

/2

1

/2

1

/2

1

/2

1

/2

1

/2

1

/2

2

½

4

4

3

½

15

68

SOLUTION 6

The Board of Directors

Pategi Telecommunications Limited,

Share,

Kwara State

Dear Sir,

Pategi Telecommunications Limited

Tax Liabilities for the Assessment Year 2015

We write to advise on the above.

The company will be assessed on the restricted income as determined under

workings (1) – (6) and the Income Tax Payable in 2015 Year of Assessment shall be

N26,257,532.40 if the FIRS is satisfied that:

(i) The Tax authority in the US shall compute the Tax for Pategi

Telecommunications in a manner not materially different from that in

Nigeria, and

(ii) That the US authority certifies the Adjusted Profit ratio, and the Depreciation

ratio correct.

Where the above conditions do not arise, the Company shall be assessed at a Fair

percentage of the Income received in Nigeria as the Assessable profit.

Should there be any need for further clarification, please do not hesitate to contact

the undersigned.

We thank you for the opportunity given us to serve your organisation.

Yours faithfully

For: XYZ & Co.

Mr. Odonngunyan A. A.

69

SCHEDULE A


Computation of Tax Liabilities for 2015 Year of Assessment

N

Assessable Profit (Wk 5) 94,116,552.75

Capital Allowance (Wk 6) (6,591,444.75)

Total/Taxable Profit 87,525,108.00

Company Income Tax @ 30% x N87,525,108 26,257,532.40

Advice

The company will be assessed on the restricted income as determined in workings

(1)-(6) below and the Income Tax payable in 2015 Year of Assessment shall be

N26,257,532.40 if the FIRS is satisfied that:

(i) The Tax Authority in the US shall compute the Tax for Pategi

Telecommunications in a manner not materially different from that in

Nigeria, and

(ii) That the US Tax Authority certifies the Adjusted Profit ratio and the

Depreciation Ratio as correct.

Otherwise, the Company shall be assessed at a Fair Percentage of the Income

received in Nigeria as the Assessable Profit.

SCHEDULE B

WORKINGS

(i) Computation of Total income:

Transaction Routes Minutes Rates Income (N)

Nigeria Min X Rates

Nigeria to US 426,250 $0.5/ min x N198/$ 42,198,750

Nigeria to Canada 550,000 $0.5/ min x N198/$ 54,450,000

976,250 96,648,750

70

Others N

US to other parts of the world 1,705,000 $0.5/ min x N198/$ 168,795,000

US to Nigeria 374,000 $0.5/ min x N198/$ 37,026.000

US to Canada through Nigeria 794,750 $0.5/ min x N198/$ 78,680,250

2,873,750 284,501,250

Global/Worldwide income 381,150,000

(ii)


Computation of Adjusted Profits for 2015 Year of Assessment

Income derived from Nigeria 96,648,750

Income derived from other routes 284,501.250

Global/World Wide Income 381,150.000

Allowable deductions

Rent 1,100,000

Salaries and Wages 4,065,188

Administrative Expenses 4,820,750 (9,985,938)

Adjusted Profit 371,164,062

(iii) Computation of Adjusted Profit Ratio (APR)

APR = Adjusted Profit before depreciation x 100%

Global or World Wide

Income

= N371,164,062 x 100% => 97%

N381,150,000

(iv)

Computation of Depreciation Ratio (DR)

Depreciation x 100%

Global or World Wide Income

= N25,991,563 x 100%

N381,150,000

6.82%

(v) Assessable Profit = APR x Income Derived in Nigeria

= 97.38% x N96,648,750

94,116,552.75

(vi) Capital Allowance = DR x income Derived in Nigeria

= 6.82% x N96,648,750

6,591,444.75

71

EXAMINER‟S REPORT

This is essentially a computational question designed to test candidates‟ knowledge

and understanding of the Revenue/Tax Computational skills with respect to

transactions that are inter-continental. A good number of candidates attempted

the question. Candidates displayed poor understanding of the questions

requirements. Only about 20% of the candidature scored 50% and above, of the

marks allocated. Many of the candidates could not proffer their solutions in a letter

or memo format. A number of candidates also had issues proffering the solutions

in local currency.

TOTAL

MARKING GUIDE MARKS MARKS

Letter to the Company:

Address ½

Opening Paragraph ½

Conditions:

First sets of conditions 1

Second Condition ½

Closing Paragraph 1 3½

Schedule I

Assessment Year

Assessable Profit

Capital Allowance

Total Profit

Tax Liability

Schedule II (Computation of Total Income)

Transaction Route

Nigeria to US

Nigeria to Canada

Other Routes

US to other parts of the World

US to Nigeria

US to Canada through Nigeria

Global/World Wide Income

Allowable Deductions:

Rents

Salaries & Wages

Admin Expenses

Adjusted profit

Adjusted profit Ratio

Computation of Depreciation Ratio

Assessable Profit

Capital Allowance

1

¼

¼

½

½

2½

½

½

½

½

½

½

½

½

½

½

½

½

½

½

1½

2

½

1½

1½

2

15

72

SOLUTION 7

Chief Egodi

Ifedi Group of Companies

505 Idejo Close

Ikeja

Lagos.

Dear Sir,

RE – TAX IMPLICATIONS OF VARIOUS OPTIONS IN MERGER AND ACQUISITION

We write to advise on the above subject matter as follows:

Merger

This is an arrangement in which the Assets, Liabilities and Businesses of two or

more Companies, are invested in and carried on by one Company which may not be

one of the merging Companies and under a situation in which the new Company is

owned by the owner of the merging Companies.

Acquisition

This is the act of acquiring effective control over assets or management of a

Company by another Company by acquiring substantial Shares or voting rights of

the target Company.

a. TAX IMPLICATIONS OF ABA FOODS LTD.

MERGING WITH IFEDI FOODS AND BEVERAGE LTD.

i. Ifedi Ltd, shall continue to file annual returns not later than 6 (six)

months after its accounting year ends in accordance with section

55(3)a of CITA Cap C21 LFN 2004.

ii. Commencement rules will not be applicable to Ifedo Ltd. The Company

shall be assessed to tax on Preceding Year basis (PYB).

iii. No Initial Allowance, on assets transferred.

iv. Claims of Annual Allowance on Tax Written-Down Values (TWDV) of

the assets transferred.

v. All Fees paid will be liable to VAT and WHT.

vi. Stamp Duties will be paid on increase in share capital.

vii. Capital Gains tax shall be payable by shareholders of Aba Foods Ltd.

For cash received for surrendering their shares to Ifedi Ltd.

73

viii. Aba Foods Ltd. shall cease operations and cessation provisions will be

applied in determining the assessable profit of the company for

relevant years.

b. TAX IMPLICATIONS IF IFEDI FOODS AND BEVERAGE LTD. IS RE-CONSTITUTED

TO TAKE OVER THE ASSETS AND LIABILITIES OF ABA FOODS LTD.

i. There will be no application of the Commencement and Cessation

rules.

ii. All Assets/qualified Capital Expenditure transferred are deemed to

have been made at their Tax written down value (TWDV).

iii. In the computation of Capital Allowance, no Initial allowance may be

computed while the Annual allowance would be based on the

unexpired tax life of the qualifying Capital expenditure.

iv. Any unutilised Capital Allowances transferred, are deemed to have

been transferred prior to sale.

v. Reconstituted Ifedi Ltd. shall pay Stamp Duties for any increase in

Share Capital as a result of the arrangement.

vi. Unrelieved losses of Aba Foods Ltd. shall be carried forward for relief

by the reconstituted Ifedi Foods Ltd. and it shall be deemed to have

been incurred by the reconstituted Ifedi Foods Ltd.

c. TAX IMPLICATIONS, IF IFEDI FOODS AND BEVERAGE LTD. AND ABA FOODS

LTD. ENTER INTO A JOINT VENTURE AGREEMENT OR PARTNERSHIP

1. The Joint Venture/Partnership itself, is not chargeable to tax.

2. The profit chargeable to Tax in the hand of each of the Partners is the

share of profit from the Partnership

3. Share of Loss from the Joint Venture or Partnership can only be

relieved from the Profits of the Joint Venture or Partnership business.

4. Capital allowances on the Assets of the Joint Venture/Partnership shall

be shared in the agreed profit and loss ratio.

5. Where any of the Companies involved in the Partnership has another

line of business, the loss generated from the business will not be

available for relief against the profit generated from the Partnership.

Yours faithfully,

For: Aluya & Co.

(Chartered Accountants)

74

EXAMINER‟S REPORT

This question tests candidates‟ understanding on the tax implications of the merger

of two existing companies, where one takes over all the assets and liabilities of the

other.

Many of the candidates attempted the question and performance was generally

below average. Candidates are advised to be more thorough and painstaking in

analysing the requirements of any question, before proffering solutions. They are

also advised to make use of ICAN Study Texts.

MARKING GUIDE MARKS TOTAL

MARKS

Address ½

Topic/Title ½

Definition of Merger 1

Definition of Acquisition 1 3

Tax Implication

a Inherits the Assets and Liabilities (any 4 correct points) 4

B Reconstitution of Assets and Liabilities (any 4 correct points) 4

c Enter into Joint Venture or Partnership 4

15

75



STRATEGIC FINANCIAL MANAGEMENT

Time Allowed: 31

/4 hours (including 15 minutes reading time)




QUESTION 1

Lekki Plc. is a supplier of specialist engineering components to the defence and

airline industries. In spite of the impact of the global recession, demand for the

company's products has gone up in recent times and is expected to pick up further

in the next two years.

As part of a recent strategic review, the directors have made the following

projections for the years ending March 31, 2018 and 2019:

(i) An anticipated increase in annual revenues of 8% per year in each of the

years;

(ii) An anticipated increase in operating costs (excluding depreciation) of 4%

per year in each of the years;

(iii) For the next two years, tax will continue to be paid at a rate of 21% and

payable in the year in which the liability arose;

(iv) The ratio of trade receivables to revenue will remain the same in each of

the next two years as well as the ratio of trade payables to operating costs

(excluding depreciation);

(v) An anticipated increase in inventory levels of 10% in the year ending March

31, 2018 but remaining stable thereafter;

(vi) The Non-current assets in the company's Statement of Financial Position are

Lekki Plc.‟s headquarters and main factory complex, both of which are

freehold premises. The company's accounting policy is that these assets are

not depreciated. Capital allowances on them are negligible and can be

ignored;

(vii) The company's annual dividend growth rate will remain at 6% per year.

Annual dividends are declared at the year end and paid in full during the

following financial year;

76

(viii) To cope with the anticipated growth in business, the company will shortly

purchase a new machinery at a cost of N8million. All the existing

machinery are rented and their rental costs are included in operating costs.

The company does not intend to seek any equity or long-term debt

financing in respect of the machinery purchase, as it intends to

accommodate the purchase within existing overdraft facilities available to

the company. The new machinery will be depreciated on a straight-line

basis over 8 years (assuming a residual value of N1million) with a full

year's depreciation to be charged in the year of purchase. Capital

allowances on a reducing balance basis at a rate of 18% per year will be

applicable on the new machinery from the year of acquisition; and

(ix) As a result of the machinery purchase, there will be an anticipated increase

in finance costs of 50% in the year ending March 31, 2018, but remaining

stable in the following year.

Extracts from the company's most recent financial statements are provided

below:

Income Statement for the year ended March 31, 2017

N'000

Revenue 60,240

Operating costs (49,500)

Operating profit 10,740

Finance costs (800)


Tax (2,286)

Profit after tax 7,654

Statement of Financial Position as at March 31, 2017

N'000 N'000

Assets

Non-current assets 28,850

Current assets

Inventories 9,020

Trade receivables 9,036

Cash and cash equivalents 396

18,452

47,302

Equity and liabilities

Equity

Ordinary share capital 16,700

Retained earnings 12,482

29,182

Non-current liabilities

6% Debentures (2025) 8,000

77

Current liabilities

Trade payables 7,336

Dividends 2,784

10,120

47,302

Assume today is April 1, 2017.

Required:

a. Prepare a Forecast Financial Statement (comprising Income Statement,

Statement of Financial Position and Cash Flow Statement) for each of the

years ending March 31, 2018 and March 31, 2019. (24 Marks)

Note: All calculations should be rounded up to the nearest N'000.

b. Beyond March 31, 2019 the directors are considering a suggestion by the

Finance Director that one of Lekki Plc.‟s smaller subsidiaries be disposed of

because, relative to most of the other company‟s operations, it is performing

poorly. Whilst the directors are broadly supportive of the Finance Director's

suggestion, they are keen to avoid liquidation of the subsidiary as they are

conscious of the industrial relations problems that might arise from the

consequent redundancies.

Required:

Discuss THREE methods, other than liquidation, that the firm might consider to

effect the divestment of this subsidiary company. (6 Marks)

(Total 30 Marks)


(40 MARKS)

QUESTION 2

Raymond Plc. is a successful IT services company incorporated 10 years ago. It was

listed on the Stock Exchange 3 years ago. The company has a broad customers base

mainly consisting of small and medium sized companies. Raymond Plc. has

achieved rapid growth in recent years by obtaining regular business from satisfied

customers and also by acquiring other IT services companies.

The Directors of Raymond Plc. have identified Harold Limited, an unlisted company,

as a possible acquisition target. Harold Limited has a number of large

multinational clients and, in general, its clients tend to be larger than those of

Raymond Plc. If successful, the acquisition would go ahead on January 1, 2018.

Forecast financial data for Raymond Plc. and Harold Limited as at December 31,

2017 are summarised below:

78

Raymond Plc. Harold Limited

Share capital (Ordinary ₦1 shares) ₦150m ₦40m

Market share price ₦4.90 N/A

N/A: Not applicable (not listed).

Additional information:

(i) If Harold Limited were to remain an independent company, its Directors

estimate that reported Profit After Tax would be ₦15million for 2018 and

then grow by 2% yearly in perpetuity;

(ii) If the acquisition were to go ahead, Raymond Plc.‟s Directors estimate that

Harold Limited‟s profit after tax would be 5% higher for 2018 than if the

company remains an independent company and that profit after tax would

then grow by 3% yearly in perpetuity;

(iii) The average ungeared Cost of Equity for the industry is 8%;

(iv) Both Raymond Plc. and Harold Limited are wholly equity financed; and

(v) Profit after tax can be assumed to be a good approximation of free cash flow

attributable to investors.

The Directors of Raymond Plc. are considering offering to purchase Harold Limited

at a price of ₦7.00 per share. It is estimated that transaction costs of ₦8million

would be payable on the acquisition and that ₦2million would be required in the

first year to cover the costs of integrating the two companies.

Required:

a. Calculate:

i. The value of Raymond Plc. as at December 31, 2017.

ii. The value of Harold Limited as at December 31, 2017 before taking the

possible acquisition of the company by Raymond Plc. into account.

iii. The overall increase in value created by the acquisition of Harold Limited

by Raymond Plc. (8 Marks)

b. i. Explain how value might be created by the proposed acquisition.

(2 Marks)

ii. Comment on the difficulties which Raymond Plc. is likely to face in

realising the potential added-value, after the acquisition. (2 Marks)

c. Evaluate the proposed offer price of ₦7.00 per share for Harold Limited from the

point of view of:

i. Harold Limited‟s shareholders.

ii. Raymond Plc.‟s shareholders. (8 Marks)

(Total 20 Marks)

79

QUESTION 3

Peter Plc. is a large, listed manufacturing company that is currently considering

how best to raise new equity finance. One option is to undertake a public issue of

new shares, a course of action that was recently approved by the shareholders.

Alternatively, the company is considering a 1 for 4 rights issue at a 10% discount to

the current market price of N5.00 per share.

The company has approached a number of investment banks regarding the

potential new rights issue and public issue. During these discussions, one

investment bank stated that the precise timing of a rights issue would be of no

consequence. The bank is of the opinion that a public issue of new shares should

not be undertaken at the present time. It therefore recommended that if the

company wishes to pursue a public issue, it should be deferred for a minimum of

six months. The bank explained that at the present time, the stock market is

significantly undervaluing Peter Plc.‟s shares. Consequently, the company would

have to issue far more shares to raise the required amount of finance than it would

have to raise in six months.

The Finance Director of Peter Plc. is, however, uncertain about this and at a recent

board meeting where the matters were discussed, she made the following

statement:

„According to the Efficient Market Hypothesis, all share prices are correct at all

times, with prices moving randomly when new information is publicly announced.

The analysts at investment banks are unable to predict future share prices.‟

Required:

a. Calculate the theoretical ex-rights price per share and the value of the rights

per existing share, assuming the company chooses this option. (2 Marks)

b. Discuss the alternative courses of action open to the owner of 500 shares in

Peter Plc. as regards the rights issue, in each case, determining the effect on

the wealth of the investor. (4 Marks)

c. Discuss the factors that will influence the actual ex-rights price per share.

(4 Marks)

d. Discuss the meaning and significance of the three forms of the Efficient

Market Hypothesis and, with specific reference to these, discuss both the

recommendation that the company waits for six months before undertaking a

public issue and the Finance Director‟s statement. (10 Marks)

(Total 20 Marks)

80

QUESTION 4

You are the Financial Director of Kudi Limited, a Nigerian Company that imports

raw materials mainly from Tiko (with T$ as currency) and exports finished products

to Katuga (with K$ as currency). Kudi is partly financed by loan raised in the

domestic market and usually hedges its foreign currency exposure by using the

forward or money markets. Most customers are allowed 3 months‟ credit. The

company has recently sold some products to a customer in Katuga for K$20 million.

The following information is available:

Exchange rate K$ per N T$ per N

Spot rate 1.9600 1.4600

1 month forward rate 1.9580 1.4579

Central Bank base rate per annum Nigeria Katuga Tiko

5.5% 4.25% 3.75%

Required:

a. Comment on the Interest Rate Parity and Purchasing Power Parity methods for

estimating exchange rates. (6 Marks)

In answering each of the following questions, include appropriate

calculations, where relevant, to aid your discussion:

i. As interest rates are higher in Nigeria than in Tiko, should T$ be

depreciating against naira, hence trading at a discount? (3 Marks)

ii. What 3-month K$ forward rate of exchange is implied by the

information given, and therefore what naira receipts can the company

expect in 3 months‟ time from the customer in Katuga?

(3 Marks)

iii. Would a sensible policy be: to buy T$ on the spot market now and place

it on deposit until when needed by Kudi? (3 Marks)

b. Discuss the concept and the significance of foreign exchange economic

exposure to a multinational company. (5 Marks)

Total 20 Marks)

81

SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS

(30 MARKS)

QUESTION 5

Private sector companies have multiple stakeholders who are likely to have

divergent interests.

Required:

a. Identify FIVE stakeholder groups and discuss briefly their financial objectives.

(10 Marks)

b. Explain ways in which companies‟ directors can be encouraged to achieve the

objective of maximisation of shareholders‟ wealth. (5 Marks)

(Total 15 Marks)

QUESTION 6

You have recently taken up employment with Large Plc., a Nigerian company with

manufacturing subsidiaries in many countries across Africa. As the Financial

Analyst, you report directly to the Managing Director who currently requires

briefings on the following areas:

(i) Ethical issues and capital investment decisions,

(ii) Options and company valuation

Required:

a. Explain, with examples, ethical issues that might affect capital investment

decisions and discuss the importance of such issues for Strategic Financial

Management. (8 Marks)

b. Explain the circumstances in which the Black-Scholes Option Pricing (BSOP)

model could be used to assess the value of a company, including the data

required for the variables used in the model (7 Marks)

(Note: A report format is not required) (Total 15 Marks)

QUESTION 7

a. In the context of the selection and holding of investments, discuss each of the

following scenarios:

i. An investor holding only one security needs to be concerned with

unsystematic risk of that security. (3 Marks)

ii. However, an investor who holds a number of securities should take

account of total risk. (3 Marks)

82

iii. An investor should never add to a portfolio investment that yields a

return less than the market rate of return.

(3 Marks)

b. The equity beta of KT Plc. is 1.2 and the equity alpha is 1.4. Explain the

meaning and significance of these values to the company. (6 Marks)

(Total 15 Marks)

83

Formulae

Modigliani and Miller Proposition 2 (with tax)

𝐾𝐸𝐺 = 𝐾𝐸𝑈 + 𝐾𝐸𝑈 − 𝐾𝐷 𝑉𝐷𝑉𝐸𝐺

(1 − 𝑡)

Asset Beta

𝛽𝐴 = 𝑉𝐸

(𝑉𝐸 + 𝑉𝐷(1 − 𝑇))𝛽𝐸 +

𝑉𝐷(1 − 𝑇)

(𝑉𝐸 + 𝑉𝐷(1 − 𝑇))𝛽𝐷

Equity Beta

𝛽𝐸 = 𝛽𝐴 + (𝛽𝐴 − 𝛽𝐷) 𝑉𝐷𝑉𝐸 (1− 𝑡)

Growing Annuity

𝑃𝑉 =𝐴1

𝑟 − 𝑔 1−

1 + 𝑔

1 + 𝑟 𝑛

Modified Internal Rate of Return

𝑀𝐼𝑅𝑅 = 𝑃𝑉𝑅𝑃𝑉𝐼

1𝑛 1 + 𝑟𝑒 − 1

The Black-Scholes Option Pricing Model

C0 = S

0N(d

1) – Ee

-rt

N(d2)

𝑑1 =𝐼𝑛

𝑆0

𝐸 + (𝑟 + 0.5𝜎2)𝑇

𝜎 𝑇

d2= d

1 - 𝜎 𝑇

The Put Call Parity

C + Ee-rt

= S + P

Binomial Option Pricing

𝑢 = 𝑒𝜎× 𝑇/𝑛

d = 1/u

𝑎 = 𝑒𝑟𝑇/𝑛

𝜋 = 𝑎 − 𝑑

𝑢 − 𝑑

The discount factor per step is given by = 𝑒−𝑟𝑇/𝑛

The Miller-Orr Model

𝑆𝑝𝑟𝑒𝑎𝑑 = 3 x

34

x Transaction Cost x Variance of Cash flows

Interest rate as a proportion

13

84

Annuity Table

Present value of an annuity of 1 =

(()discount rate 1

1 - (1 + r)-n

r

Where r = discount rate

n = number of periods

Discount rate (r)

Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1

2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2

3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2.487 3

4 3·902 3·808 3.717 3·630 3.546 3.465 3·387 3·312 3·240 3·170 4

5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3.890 3·791 5

6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4.486 4·355 6

7 6·728 6.472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7

8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8

9 8·566 8·162 7·786 7.435 7·108 6·802 6·515 6·247 5·995 5·759 9

10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6.418 6·145 10

11 10·368 9·787 9·253 8·760 8·306 7·887 7.499 7·139 6·805 6.495 11

12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7'161 6·814 12

13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13

14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14

15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1

2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2

3 2.444 2.402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3

4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2.690 2·639 2.589 4

5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5

6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3.498 3.410 3·326 6

7 4·712 4·564 4.423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7

8 5·146 4·968 4.799 4·639 4.487 4·344 4·207 4·078 3·954 3·837 8

9 5·537 5·328 5·132 4·946 4·772 4·607 4.451 4·303 4·163 4·031 9

10 5·889 5·650 5.426 5·216 5·019 4·833 4·659 4.494 4·339 4·192 10

11 6·207 5·938 5·687 5.453 5·234 5·029 4·836 4·656 4.486 4·327 11

12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4.439 12

13 6·750 6.424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13

14 6·982 6·628 6·302 6·002 5·724 5.468 5·229 5·008 4·802 4·611 14

85

15

7·191 6·811 6.462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15

86

SOLUTION 1

a) (i) Forecast Income Statements for the years ending 31 March

N'000 N'000

Revenue 65,059 70,264

Operating costs (excluding depreciation) (51,480) (53,539)

Depreciation (875) (875)

Operating profit 12,704 15,850

Finance costs (1,200) (1,200)

Profit before tax 11,504 14,650

Tax (W1) (2,297) (3,012)

Profit after tax 9,207 11,638

Dividends (2,951) 3,128

Retained profit 6,256 8,510

WORKINGS (W1)

Tax


Add back depreciation 875 875

Capital allowances (1,440) (1,181)

Taxable profits 10,939 14,344

Tax@ 21% 2,297 3,012

(ii) Forecast Statements of Financial Position as at 31 March

2018 2019

N'000 N'000

ASSETS

Non-current assets 35,975 35,100

Inventories 9,922 9,922

Receivables 9,759 10,540

Cash (balancing figure) - 7,449

TOTAL ASSETS 55,656 63,011

EQUITY AND LIABILITIES

Ordinary share capital 16,700 16,700

Retained earnings 18,738 27,248

Debentures 8,000 8,000

Payables 7,629 7,935

Bank overdraft (balancing figure) 1,638 -

Dividends 2,951 3,128

TOTAL EQUITY AND LIABILITIES 55,656 63,011

87

(iii) Forecast Cash Flow Statements for the years ending 31 March

2018 2019

N'000 N'000


Depreciation 875 875

Increase in inventories (902) -

Increase in receivables (723) (781)

Increase in payables 293 306

Purchase of non-current assets (8,000) -

Tax paid (2,297) (3,012)

Dividends paid (2,784) (2,951)

Net cash flow (2,034) 9,087

Cash balance brought forward 396 (1,638)

Cash balance carried forward (1,638) 7,449

b)

(i) Management Buy-out: a new company acquires either the trade and

assets or the shares of the subsidiary to be sold, with the purchase

usually funded by a mix of debt and equity provided by the managers

(equity), venture capital providers (debt and equity) and other financiers

(debt).

(ii) Management Buy-in: as in (i) above, but with purchase by a group of

external managers.

(iii) Spin-off (demerger): shareholders are given shares in the new entity pro-

rata to their shareholdings in the parent company - there is no change in

ownership; with separate legal identities established; used to avoid the

problems of the conglomerate discount; sometimes used as a defence

against takeover of the entire business.

(iv) Sell-off: The business is sold to another company usually for cash.

(v) Carve-out: where shares of the subsidiary are sold to the public through

initial public offer resulting in cash inflow to the holding company.

(vi) Split-off: a means of re-organising an existing corporate structure in

which the share of a business division, subsidiary or newly affiliated

company is transferred to the shareholders of the parent company in

exchange for shares in the latter.

88

ALTERNATIVE SOLUTION TO A(iii)

FORECAST CASH FLOW STATEMENTS FOR THE YEAR ENDING 31 MARCH -

RECEIPTS AND PAYMENTS METHOD

2018 2019

N‟000 N‟000

Sales collection* (K) 64,336 69,483

Payments:

Operating costs** 51,187 53,233

Additional inventory 902 -

Non-current assets 8,000 -

Finance cost 1,200 1,200

Tax 2,297 3,012

Dividend 2,784 2,951

Total payments (T) 66,370 60,396

Excess of receipts Over payments (K – T) (2,034) 9,087

Opening balance 396 (1,638)

Closing balance (1,638) 7,499

EXAMINER‟S REPORT

Part „a‟ of the question tests the ability of the candidates to project financial

statements using a given scenario, while Part „b‟ deals with various methods of

divestment.

Being a compulsory question, virtually all the candidates attempted the question.

Although, we have some exceptionally good scripts, the average level of

performance was very poor.

The key pitfalls include:

Failure to include depreciation and finance cost in the income statement;

Calculation of income tax based on accounting profit rather than adjusted

profit (i.e. not adjusting for depreciation and capital allowances);

Incorrect calculation of retained earnings; and

Opening receivable 9,036 9,759

Sales 65,059 70,264

Closing receivable (9,759) (10,540)

Collection * 64,336 69,483

Balance b/f 7,336 7,629

Operating costs 51,480 53,539

Balance c/f (7,629) (7,935)

Amount paid ** 51,187 53,233

89

Basing dividend cash flow on current year‟s dividend rather than the

preceeding year‟s as clearly instructed in the question.

Candidates are strongly advised to practise examination-type questions.

Marking Guide

(a) i) Income statement Marks Marks

Revenue 1

Operating costs 1

Depreciation ½

Operating profit 1

Finance costs ½

Profit before tax ½

Tax 3

Profit after tax 1

Dividends 1

Retained profit ½ 10

ii) Statement of financial position

Payables 1

Receivables 1

Cash/overdraft 2

Others 4 8

iii) Cash flow

Dividend paid 1

Others 5 6

24

b) 2 points per method 6

30

90

SOLUTION 2

a) ₦m

Pre-acquisition value:

(i) Raymond Plc. ₦4.90 × 150m = 735

(ii) Harold Limited 𝑁15𝑚

0.08 − 0.02

= 250

985

(iii) Post-acquisition value: ₦m

Harold Limited 𝑁15𝑚 × 1.05

0.08 − 0.03

= 315.00

Raymond Plc. = 735.00

Transaction costs = (8.00)

Integration costs

𝑁2𝑚1.08

= (1.85)

Total value 1,040.15

Pre-acquisition total value (985.00)

Incremental value 55.15

b) i) Value can be created by combining the two companies through the

achievement of synergies and economies of scale. In most business

combinations, there are likely to be savings generated from combining

operations and reducing the amount of resources needed to fund central

functions such as human resources, finance and treasury. The cost savings

are likely to have an almost immediate impact on the cash flow and hence

are likely to be reflected in 5% growth in free cash flow in the first year.

Synergies might also arise in respect of the cross-selling of services between

the two companies to their respective client bases. It is possible that the

directors of Raymond Plc. anticipate that there are opportunities to enhance

the cash flows of Harold Limited by utilising the expertise of Raymond Plc.

leading to a higher growth rate of 3% a year compared to 2%.

ii) Key challenges in realising the potential added value after the merger are:

Success depends on the extent that Harold's management and staff

accept the transfer of ownership and remain committed to servicing

Harold Limited‟s clients to the best of their ability. To overcome this

challenge, Raymond Plc. should consider introducing an incentive

scheme such as a bonus payment or employee‟s share option scheme;

It also depends on whether Harold's clients are happy with the new

arrangement and are confident of receiving the same level of service as

before; and

The reliability of the forecast improvement in earnings and growth is also

key to successful realisation of the potential added value.

91

c) Consideration paid: ₦7 × 40 million shares = ₦280 million

Comparison of shareholders‟ wealth before and after the acquisition:

Raymond Plc. Harold

Limited

Total value

Before the acquisition

After the acquisition

Share of synergistic benefits

₦735million

N760million

=(N1,040m - N 280m)

₦25million

₦250million

₦280million

(proceeds)

₦30million

₦985million

₦1,040million

Harold Limited‟s shareholder‟s perspective: Very attractive. Harold Limited‟s

shareholders can expect to receive 55% of the synergistic benefits of the merger

which does not seem to be a fair split considering:

Harold Limited is the smaller company and contributing less to the merger;

Harold Limited‟s shareholders do not carry any of the risks that the

synergistic benefits cannot be realized; and

Harold Limited is unlisted and it is therefore very difficult for the

shareholders to realise their investment at all, let alone at such a generous

price which is above the company‟s own bullish value estimates derived

from discounted cash flow analysis.

Raymond Plc.‟s shareholders‟ perspective: Possibly too high a price for comfort.

The main reasons for this conclusion are as follows:

The reverse of the above: Raymond Plc.‟s shareholders take all the risk and

contribute most value to the combined business and yet only expect to

receive 45% of the increase in value; and

It is likely that Harold Limited has a higher business risk than Raymond Plc.

despite being in the same industry because of the different clients profile. If

one customer were to be lost by Harold Limited, then this could have a

significant impact on cash flow and hence the variability of Harold Limited‟s

cash flows is likely to be higher than for Raymond Plc. Therefore, it is

possible that a higher discount rate should be used to value Harold Limited

which would have the effect of reducing its value.

Conclusion: The price needs to be reduced. The proposed price is not fair to

Raymold Plc‟s shareholders and Harold Limited is potentially over-valued at a

discount rate of 8%.

92

EXAMINER‟S REPORT

The question tests candidates‟ ability to value companies for acquisition.

About 40% of the candidates attempted the question and performance was very

poor with some candidates scoring zero.

About 80 percent of the candidates that attempted the question made use of wrong

formulae in discounting the given cash flows and could not carry out the required

analysis of their results.

It is recommended that candidates preparing for this examination need to practise

past examination questions.


a) Pre-acquisition value:

Raymond Plc. 1

Harold Limited 2

Post-acquisition

- Harold Limited 2

- Transaction costs ½

- Integration costs 1

Incremental value 1½ 8

b) i) Sensible suggestions 2

ii) 1 mark per explained point (max 2) 2 4

c) Share of synergy

- Raymond Plc. 1½

- Harold Limited 1½

Evaluation – Raymond Plc. 2

– Harold Limited 2

Conclusion 1 8

20

SOLUTION 3

93

(a) The rights issue price =N5.00 x 0.90 = N4.50

The theoretical ex-rights price =[(4 x N5.00) + (1 x N4.50)]/5 = N4.90

The value of the rights per existing share = (4.90 – 4.50)/4 = N0.10

(b) The value of 625 shares after the rights issue =625 x N4.90 = N3,062.50

The value of 500 shares before the rights issue =500 x N5.00 = N2,500.00

The value of 500 shares after the rights issue =500 x N4.90 = N2,450.00

The amount of cash subscribed for the new shares =125 x N4.50 = N562.50

The amount of cash raised from the sale of rights =500 x N0.10 = N50.00

Options:

The shareholder could either do nothing, take up the rights, sell the rights or

exercise his rights in respect of part of the issue and sell the remaining to pay

or part pay for the issue taken up.

The effect on the shareholder‟s wealth depends on the action taken:

i) If the shareholder takes up the rights, the rights issue will have a

neutral effect on his wealth. As an owner of 500 shares, he will

purchase an additional 125 shares and the value of the total 625 shares

(N3,062.50) will be the same as the value of 500 shares before the

rights issue (N2,500.00) plus the cash subscribed for the new shares

(N562.50). The make-up of the shareholder‟s wealth will have changed

(less cash, more shares), but not his total wealth;

ii) If the shareholder sells his rights, the rights issue will also have a

neutral effect on his wealth. The value of 500 shares after the rights

issue (N2,450.00) plus the cash received from selling the rights

(N50.00) equals the value of 500 shares before the rights issue

(N2,500.00). Again, the make-up of the shareholder‟s wealth will have

changed (more cash, less shares), but not his total wealth;

iii) If the shareholder neither takes up the rights nor sells the rights, a loss of

wealth of N50 will occur, representing the difference between the value

of 500 shares before the rights issue (N2,500.00) and the value of 500

shares after the rights issue (N2,450.00); and

iv) If the shareholder takes up 75 of the rights issue and sells the remaining

50 shares, it will have a neutral effect on his wealth.

(c) Factors that may influence the actual share price following the rights issue

include:

i) The expectations of investors/the stock market regarding the company‟s

future;

ii) The level of take-up of the rights issue – if the issue was not fully taken

up, for example, the share price might fall;

94

iii) Information regarding the use to which the proceeds will be put and the

market‟s reaction to that information – possibly being used to restructure

finances in a way that affects the company‟s cost of capital; or being

used in a project with a positive net present value;

iv) General stock market conditions/sentiment at the time of the issue, or

conditions/sentiment within the company‟s particular sector of the stock

market;

v) The existence of specific information (positive or negative) regarding the

company or its sector at the time of the issue; and

vi) It is assumed that the details of any new investment/strategy are

communicated to and believed by, the stock market. If this is not the

case, then the share price will differ from the theoretical ex-rights price.

In other words, the degree of efficiency of the market could impact on

the actual share price.

(d) The three forms of theoretical stock market efficiency are weak, semi-strong

and strong.

If a stock market has weak form efficiency then only past information is

currently reflected in share prices. Weak form efficiency, therefore, implies

that share prices fully and fairly reflect all past information about the share

and investors cannot, therefore, make abnormal gains by studying and acting

upon any past information.

If a stock market has semi-strong form efficiency then not only all past

information but also all publicly available current information (eg financial

statements, press reports) are currently reflected in share prices. Semi-strong

form efficiency, therefore, implies that share prices fully and fairly reflect all

past and current publicly available information and investors cannot,

therefore, make abnormal gains by studying and acting upon any such

information.

If a stock market has strong form efficiency then not only all past and current

publicly available information but also all relevant private information (eg

board minutes) is currently reflected in share prices. Strong form efficiency,

therefore, implies that share prices fully and fairly reflect all past, current

publicly available and private information and investors cannot, therefore,

make abnormal gains by acting upon information of any sort.

The implication of all these, is that, if the stock market is efficient in all the

three forms, investors cannot beat the market by having superior information

as it does not, by definition, exist. However, if the stock market is not strong

form efficient then abnormal gains can be made from possession of private

(insider) information.

95

Discussion

Empirical evidence suggests that stock markets are uncertainly not strong

form efficient, so the bank‟s claim appears misguided. There is much

empirical evidence however, that most stock markets are semi-strong efficient

and so, it is unlikely that the company‟s shares are undervalued and certainly

not to any extent that might justify deferring a public issue.

Regarding the Finance Director‟s statement, its accuracy depends in part, on

which form of market efficiency is evident. Strong form efficiency does

suggest that share prices are „correct‟ (they reflect true values) at all times,

but the other two forms of efficiency would not generate „correct‟ share prices

as they do not fully consider all information. However, even with a strong

form efficient market, there may be a time lag between the emergence of new,

relevant information and the market reaction to it, meaning that for a time

prices will not be „correct‟.

Finally, as regards the ability of analysts to predict future share prices, if the

stock market is strong form efficient then analysts will be unable to achieve

consistently superior rates of return. But that does not mean they cannot

predict share prices – by chance they may do so on occasions, but the

implication is that they will be unable to do so consistently. However, if the

market is only semi-strong form efficient, then if the analysts have access to

any private information then they may be able to predict the future share

price and make superior rates of return.

EXAMINER‟S REPORT

The first part of the question tests candidates‟ knowledge of the analysis of right

issue while the second part tests the knowledge of Efficient Market Hypothesis.

More than 80% of the candidates attempted the question but, the level of

performance was disappointing. It is highly troubling that candidates writing the

final examination could not compute ex-right price and for those who did, they

could not analyse the effect of the right issue on shareholders‟ wealth.

In future, candidates are advised to improve their analytical skill. They need to

read widely and practise with past examination questions.


(a) Ex-rights price ½

Theoretical ex-rights/price 1

Value of a right ½ 2

(b) Analysis of wealth

- right taken up 1

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- right sold 1

- no action taken 1

- Part of the right taken up and

Balance sold 1 4

(c) 1 mark per point (max 4) 4

(d) 2 marks for each (2 x 3) 6

Conclusion 1

Discussion 3 10

20

SOLUTION 4

a) There are two important theories linking exchange rates, interest rates and

inflation rates which need to be considered when determining strategies in

this area.

Interest Rate Parity

Interest Rate Parity (IRP) is based on the hypothesis that the difference

between interest rates in the two countries should offset the difference

between the spot rates and the forward foreign exchange rates over the same

period. Specifically, if investors can obtain a higher risk-free rate in one

currency than they can in the other, the country offering the higher rate will

have its currency depreciated against the other. For example, if risk-free rate

in Ghana is 10% and it is 6% in Nigeria, the Cedi will depreciate against the

Naira by approximately 4% per year.

The relevant formula is:

Where A and B are two different countries.

Purchasing Power Parity

Purchasing Power Parity (PPP) states that the exchange rate between two

currencies is equal to the ratio of the currencies‟ respective purchasing power.

It states that the rate of appreciation of a currency is equal to the difference in

inflation rates between the foreign and the home country. For example, if

South Africa has an inflation rate of 1% and Nigeria has an inflation rate of

3%, the Nigerian Naira will depreciate against the South African rand by 2%

per year.

The relevant formula is:

i) T$ forward rate

Forward rate currency 𝐴 B = Spot 𝐴 𝐵 × 1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐴 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

1 + 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐵 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

Forward rate currency 𝐴 B = Spot 𝐴 𝐵 × 1 + 𝐴 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

1 + 𝐵 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

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ii) The forward rate between T$ and Naira (N) is predicted by IRP.

The difference between the spot rate and the forward rate of T$0.0021

represents a small discount on Naira (or a premium on T$) suggesting

that the Naira is depreciating (or T$ is appreciating).

The net effect is that a Nigerian investor can either

Invest in Nigeria at 5.5%, or

Invest in Country T at 3.75% but also benefit from an appreciating

currency giving the same overall return.

ii) Again IRP can be used to estimate the forward rate.

With forward contract, the expected receipt = K$20,000,000 ÷ 1.9540

= N10,235,415

iii) Placing T$ on deposit

The arrangement described is money market hedge, buying the currency,

putting it on deposit and using the principal and interest to make the T$

payment when it falls due.

Money market hedging may be slightly more beneficial than using the

forward exchange markets, but the difference is likely to be small, as the

premium or discount on the forward exchange rates will reflect interest

rate differentials. Money market hedging is currently a strategy that the

company uses.

Therefore, the policy described above is more sensible and should be

adopted.

b) Economic exposure is the risk that the present value of a company's future

cash flows might be reduced by unexpected adverse exchange rate

movements. Economic exposure includes transaction exposure, that is, the risk

of adverse exchange rate movements occurring in the course of normal

international trading transactions.

Implications of economic exposure:

i) Effect on international competitiveness

This can affect companies through its purchases (where raw materials

from abroad become more expensive because of a devaluation of the

home currency) or its sales (where an appreciation in the home currency

One month forward rate T$/N = 1.4600 × 1 + 0.0375 12

1 + 0.0550 12 = 1.4579

3 −month forward rate K$/N = 1.960 × 1 + 0.0425 4

1 + 0.0550 4

= 1.9540

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will mean that sales priced in foreign currencies will be worth less in

home currency terms).

ii) Effect on remittances from abroad

If a subsidiary is set up in an overseas country, and that country's

exchange rate depreciates against the home exchange rate, the

remittances will be worth less in home currency terms each year.

iii) Effect on accounts

Investors will identify economic exposure as having an adverse effect on

accounts if the markets are efficient.

iv) Effect on operations and financing

In order to hedge the adverse effects of economic exposure, companies

will consider diversification of operations, so that sales and purchases

are made in a number of different currencies. The financing of

operations can also be done in a large number of currencies.

EXAMINER‟S REPORT

This question tests candidates‟ knowledge of the use of interest rate parity theorem

and purchasing power parity theorem to estimate foreign exchange rate.

More than 60% of the candidates attempted the question but majority of them

generated unacceptable solutions hence, performance was very poor.

Key pitfalls include:

Failure of the candidates to cover the risk management part of the syllabus;

Inability to identify the difference between direct and indirect quotes;

Use of inappropriate formulae; and

Use of annual interest rates to calculate 3-month forward rate, etc.

Candidates are reminded that questions for each examination are designed to cover

all sections of the syllabus, hence, they are advised to cover all aspects of the

syllabus when preparing for the examinations of the Institute.


(a) Interest parity 3

Purchasing power parity 3 6

Calculation and conclusion

i. T$ forward rate 3

ii. R$ 3 months forward rate 2

Expected receipt 1 3

iii. Correctly identifying the scenario as

money market hedge 2

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Recommendation 1 3

(b) Explanation of economic exposure 2

Implications 3 5

20

SOLUTION 5

a) Stakeholders in a company include amongst others: shareholders; directors

/managers; lenders; employees; suppliers; customers; and government. These

groups are likely to share in the wealth and risk generated by a company in

different ways and thus conflicts of interest are likely to exist. Conflicts also

exist not just between groups but within stakeholder groups. This might be

because sub-groups exist, for example preference shareholders and equity

shareholders within the overall category of shareholders.

Alternatively, individuals within a stakeholder group might have different

preferences (e.g. to risk and return, short term and long term returns). Good

corporate governance is partly about the resolution of such conflicts. Financial

and other objectives of stakeholder groups may be identified as follows:

Shareholders

Shareholders are normally assumed to be interested in wealth maximisation.

This, however, involves consideration of potential return and risk. For a listed

company, this can be viewed in terms of the changes in the share price and

other market-based ratios using share price (e.g. price/earnings ratio,

dividend yield, earnings yield etc).

Where a company is not listed, financial objectives need to be set in terms of

other financial measures, such as return on capital employed, earnings per

share, gearing, growth, profit margin, asset utilisation and market share.

Many other measures also exist which may collectively capture the objectives

of return and risk.

Shareholders may have other objectives for the company and these can be

identified in terms of the interests of other stakeholder groups. Thus,

shareholders as a group may be interested in profit maximisation. They may

also be interested in the welfare of their employees, or the environmental

impact of the company's operations.

Management

While executive directors and managers should attempt to promote and

balance the interests of shareholders and other stakeholder groups, it has

100

been argued that they also promote their own individual interests and should

be seen as a separate stakeholder group.

This problem arises from the divorce between ownership and control. The

behaviour of managers cannot be fully observed by the shareholders, giving

them the capacity to take decisions which are consistent with their own

reward structures and risk preferences. Directors may therefore be interested

in their own remuneration package.

They may also be interested in building empires, exercising greater control, or

positioning themselves for their next promotion. Non-financial objectives of

managers are sometimes inconsistent with what the financial objectives of the

company ought to be.

Lenders

Lenders are concerned to receive payment of interest and eventually re-

payment of the capital at maturity. Unlike the ordinary shareholders, they do

not share in the upside (profitability) of successful organisational strategies.

They are therefore likely to be more risk averse than shareholders, with an

emphasis on financial objectives that promote liquidity and solvency with low

risk (e.g. low gearing, high interest cover, security, strong cash flow).

Employees

The primary interests of employees are their salary/wage and the security of

their employment. To an extent there is a direct conflict between employees

and shareholders as wages are a cost to the company and income to

employees.

Performance-related pay, based on financial or other quantitative objectives

may, however, go some way toward drawing the divergent interests together.

Suppliers and Customers

Suppliers and Customers are external stakeholders with their own set of

objectives (profit for the supplier and, possibly, customer satisfaction with the

goods or services) that, within a portfolio of businesses, are only partly

dependent on the company in question. Nevertheless, it is important to

consider and measure the relationship in term of financial objectives relating

to quality, lead times, volume of business, price and a range of other variables

in considering any organisational strategy.

Government – Interested in payments of tax for planning purposes and the

operating environment.

b) The directors of companies can be encouraged to achieve the objective of

maximising shareholders‟ wealth through managerial reward schemes and

through regulatory requirements.

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Managerial reward schemes

As agents of the company‟s shareholders, the directors may not always act in

ways which increase the wealth of shareholders, a phenomenon called the

agency problem. They can be encouraged to increase or maximise

shareholders‟ wealth by managerial reward schemes such as performance-

related pay and share option schemes. Through these methods, the goals of

shareholders and directors may increase in congruence.

Performance-related pay, links part of the remuneration of directors to some

aspect of corporate performance, such as levels of profit or earnings per share.

One problem here is that it is difficult to choose an aspect of corporate

performance which is not influenced by the actions of the directors, leading to

the possibility of managers influencing corporate affairs for their own benefit

rather than the benefit of shareholders, for example, focusing on short-term

performance while neglecting the longer term.

Share option schemes bring the goals of shareholders and directors closer

together to the extent that directors become shareholders themselves. Share

options allow directors to purchase shares at a specified price on a specified

future date, encouraging them to make decisions which exert an upward

pressure on share prices. Unfortunately, a general increase in share prices can

lead to directors being rewarded for poor performance, while a general

decrease in share prices can lead to managers not being rewarded for good

performance. However, share option schemes can lead to a culture of

performance improvement and so can bring continuing benefit to

stakeholders.

Regulatory Requirements/ Corporate Governance

Regulatory Requirements can be imposed through Corporate Governance

codes of best practice and stock market listing regulations.

Corporate Governance codes of best practice seek to reduce corporate risk and

increase corporate accountability. Responsibility is placed on directors to

identify, access and manage risk within an organisation. An independent

perspective is brought to directors‟ decisions by appointing non-executive

directors to create a balanced board of directors, and by appointing non-

executive directors to remuneration committees and audit committees.

102

EXAMINER‟S REPORT

This question tests candidates‟ knowledge of stakeholder groups and their

objectives.

Almost all the candidates attempted the question and performance was good with

some candidates scoring all the marks. Surprisingly though, we also have some

few candidates scoring zero.

Candidates are advised to cover all aspect of the syllabus in their preparation for

future examinations.


(a) 2 marks per well explained stakeholder (max 5) 10

(b) Managerial rewards schemes 3

Regulatory requirements 2 5

15

SOLUTION 6

(a) Ethics impact on many aspects of investment decisions. In theory, companies

seek to maximise shareholders wealth, often subject to constraining

secondary objectives. Such secondary objectives include the welfare of the

public. Companies are affected by ethical standards relating to:

(i) Health and safety - Employees and the public should be protected

from danger, which includes working conditions, following

employment laws and product safety;

(ii) Environmental issues – Environmental issues such as, controlling

pollution, protecting wildlife and the countryside. Fully satisfying

these issues might be an expensive element in a capital investment;

(iii) Bribes and other payments - Investment might proceed more quickly

and efficiently if bribes, 'incentive payments', 'gifts' etc. are paid to

officials. This is a difficult area, as gifts are part of the business

culture in some countries. Even the ethics of political contributions is

debatable;

(iv) Corporate governance - Many examples exist of companies, e.g.

Enron,

where the results of investments and the true financial position have

been hidden from shareholders and the public;

(v) Taxation - Companies may try to minimise their tax liability. Tax

evasion is illegal, but there is an ethical question over the use of

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sophisticated tax avoidance measures, especially in developing

countries;

(vi) Wage levels - Should a company pay low wages to maximise

shareholders‟ wealth, especially in countries where the standard of

living is very low?

(vii) Individual manager's ethics - The ethics of individuals, including

pursuing their own goals and self-interest (such as job security) rather

than those of the organisation might influence the outcome of

investment decisions.

There is inevitably some subjectivity as to what constitutes ethical behaviour, but

there is little doubt that ethical issues are of increasing importance to companies.

Acting in an ethically responsible way often has a direct detrimental impact upon

expected cash flows and net present value (NPV). However, stakeholders, including

shareholders, are increasingly expecting companies to act ethically. If they do not,

then their share price might suffer as a result of adverse publicity and investors

withdrawing their support.

The concept of ethical shareholders‟ wealth creation is likely to become

increasingly important in strategic financial management.

b) Using the Black-Scholes Option Pricing (BSOP) model in company valuation

rests upon the idea that equity is a call option, written by the lenders, on the

underlying assets of the business. If the value of the company declines

substantially then the shareholders can simply walk away, losing the maximum

of their investment. On the other hand, the upside potential is unlimited once

the interest on debt has been paid.

The BSOP model can be helpful in circumstances where the conventional

methods of valuation do not reflect the risks fully or where they cannot be used,

for example, if we are trying to value an unlisted company with unpredictable

future growth.

There are five variables which are input into the BSOP model to determine the

value of the option. Proxies need to be established for each variable when using

the BSOP model to value a company. The five variables are: the value of the

underlying asset; the exercise price; the time to expiry; the volatility of the

underlying asset value; and the risk free rate of return.

For the exercise price, the debt of the company is taken. In its simplest form, the

104

assumption is that the borrowing is in the form of zero coupon debt, that is, a

discount bond. In practice such debt is not used as a primary source of company

finance and so we calculate the value of an equivalent bond with the same yield

and term to maturity as the company's existing debt. The exercise price in

valuing the business as a call option is the value of the outstanding debt

calculated as the present value of a zero coupon bond offering the same yield as

the current debt.

The proxy for the value of the underlying asset is the fair value of the company's

assets less current liabilities on the basis that if the company is broken up and

sold, then that is what the assets would be worth to the long-term debt holders

and the equity holders.

The time to expiry is the period of time before the debt is due for redemption.

The owners of the company have that time before the option needs to be

exercised, that is when the debt holders need to be repaid.

The proxy for the volatility of the underlying asset is the volatility of the

business' assets.

The risk-free rate is usually the rate on a riskless investment such as a short-

term government bond.

EXAMINER‟S REPORT

The question tests candidates understanding of ethical issues in capital investment

decisions and the use of Black-Scholes option pricing model in company valuation.

Less than 20% of the candidates attempted the question and performance was very

poor.

In part „a‟ of the question, candidates could not offer any meaningful ethical issues.

In part „b‟, the very few candidates that were able to identify the key variables in

Black-Scholes model failed to identify the relevant proxy for each variable within

the context of company valuation.

We recommend that candidates should make effort to cover the entire syllabus

when preparing for future examinations.

105


a) 2 marks per ethical issues

raised and explained (max 4 points) 8

b) Circumstances of use 2

1 mark per each valid variable identified 5 7

15

SOLUTION 7

a. i) Unsystematic Risk

Unsystematic risk may be defined as the risk attached to a specific

investment, in contrast to systematic risk, which is the overall market risk. As

such, it is possible by the combination of a portfolio of investments to

eliminate systematic risk through diversification. The investor who only holds

one security will therefore bear a total risk, made up of the systematic risk of

the market and the systematic risk of the investment itself.

Hence, it is incorrect to argue that an investor needs only be concerned with

the unsystematic risk of that security. On the other hand, he may well be

concerned about the systematic risk of the security, because of the fact that it

is that portion of the risk which is present simply because he holds only one,

rather than a portfolio of investments.

ii) Total Risk

In holding a portfolio of investments, the rational investor will assemble the

portfolio in such a way as to minimise the risk associated with the portfolio.

This means that in a large portfolio it is possible to diversify away the

unsystematic risk completely.

The total risk to the investor under such circumstances is only the systematic

risk of the market itself. The total risk to an investor in a number of securities

may therefore be made up of only systematic risk, or systematic plus

unsystematic risk, depending on the extent to which the portfolio is

diversified.

iii) Market Rate of Return

In deciding whether to add an investment to a portfolio, the investor should

determine the effect of the extra investment on the overall risk of the portfolio.

If the effect is to reduce the overall risk then, assuming that the investor does

seek to minimise risk, the investment should be undertaken.

106

An investment yielding a rate of return less than that of the market is one

which is of relatively low risk or possibly risk-free. It would therefore be

appropriate to add such an investment to a currently high-risk portfolio as a

means of reducing the overall level of risk. It is not relative return but the

effect on risk which should determine the investment decision.

b) The equity beta measures the systematic risk of a company‟s shares, the risk

that cannot be eliminated by diversification. It is a measure of a share‟s

volatility in terms of the market‟s risk, and may be estimated by relating the

covariance between the returns on the share and the returns on the market to

market variance. An equity beta of 1.2 suggests that KT. Plc‟s shares are more

risky than the market as a whole, which has a beta of 1. If average market

returns change, for example, increase by 5%, the return of KT. Plc‟s shares

would be expected to increase to 1.2 × 5% = 6%.

The alpha value measures the abnormal return on a share. An alpha value of

1.4% means that the returns on KT plc‟s shares are currently 1.4% more than

would be expected given the share‟s systematic risk. Alpha values are only

temporary and may be positive or negative; in theory the alpha for an

individual share should tend to zero. An alpha value of 1.4% should cause

investors to buy the share to benefit from the abnormal return, which would

increase share price and cause the return to fall until the alpha value falls to

zero. In a well-diversified portfolio the alpha value is expected to be zero.

EXAMINER‟S REPORT

The question tests candidates‟ understanding of some basic principles of portfolio

diversification.

About 90% of the candidates attempted the question and performance was average.

Part „b‟ of the question was however poorly answered with some candidates

describing alpha value as a risk measurement.

Alpha value is well discussed and illustrated in the ICAN Study Text. Candidates are

therefore advised to make use of the ICAN Study Text and other relevant materials

when preparing for the Institute‟s future examinations.

107


(a) Discussion and explanation of:

(i) Unsystematic risk 3

(ii) Total risk 3

(iii) Market rate of return 3 9

(b) The meaning and purpose of equity beta 3

The meaning and purpose of equity alpha value 3 6

15

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PROFESSIONAL LEVEL EXAMINATION - NOVEMBER 2017

ADVANCED AUDIT AND ASSURANCE

Time Allowed: 3¼ hours (including 15 minutes reading time)



SECTION A: COMPULSORY (30 MARKS)

QUESTION 1

Bode, Ugo, Musa and Company is a firm of Chartered Accountants that has existed

for over 20 years and achieved a strong reputation for quality audit work. The firm

has expanded significantly over the past ten years - doubling its client base across

the different sectors of the Nigerian economy. The firm currently audits two banks,

five listed entities and over seventy other companies. It has also increased its audit

staff base and grown the number of its partners from two to seven over the same

period.

However in the last two years, the firm has series of regulatory reviews due to a

number of instances of errors noted in some financial statements audited by the

firm. One of the clients, the shareholders of NigerKap Plc, petitioned the regulator

over a misstatement in the value of their investment property. This resulted in

overstatement of profit and overpayment of taxes by the company based on the

financial statements for the year ended December 31, 2015. The shareholders also

threatened to take legal action against the firm.

The Managing Partner (MP) of the firm is apparently very concerned about this

situation and has commenced internal procedures to evaluate the quality of audits

performed by the firm especially for the NigerKap audit of 2015. A committee set

up by him has conducted a review of a number of audit files and has noted among

others, that very poor audit work was performed by the NigerKap engagement

team of 2015 led by Amy Smith, one of the partners who is supposed to retire in

2018. The MP has therefore instructed that Oluwatoyin Bede-Nwokoye, a new

partner of the firm, should perform the 2016 audit of NigerKap Plc. The Statement

of Financial Position of NigerKap Plc as at December 31, 2016 has been provided to

the firm and some of the balances therein are shown below:

109

2016 2015

N'million N'million

Extract from Non-current assets

Property, plant and equipment 2,640 2,620

Intangible assets 1,200 900

Investment property 3,700 6,150

Deferred tax* 2,800 -

Extract from current assets

Inventories 1,350 1,100

Trade receivables 250 310

*The deferred tax relates to unused tax losses that have accumulated during the

past three years. Management is confident that there will be sufficient future

operating profits to claim the benefit of the tax losses in full in future years.

Required:

a. Discuss FOUR consequences of the poor audit work on the firm of Bode, Ugo,

Musa and Company (Chartered Accountants). (5 Marks)

b. Recommend SIX actions that the new partner should implement to ensure that

a high overall quality of the audit of 2016 financial statements of NigerKap plc

is achieved. (9 Marks)

c. What are the FOUR key audit procedures that should be carried out by the

engagement team to determine whether the recognition of the deferred tax

asset of the company in 2016 is appropriate? (8 Marks)

d. What specific audit procedures should be carried out by the audit team in

respect of the following balances in the financial statements of the company

(other than casting and agreement of amounts per schedule to the general

ledger/trial balance)?

i. Inventories balance (4 Marks)

ii. Intangible assets (4 Marks)

(Total 30 Marks)

110



QUESTION 2

Chuks Roberts Plc (CRP) operates as auto-parts manufacturing company in Nigeria

and has its head office in Lagos. It has plans to manufacture drones for the

distribution of parcels within Africa. To actualise this, it has just acquired Zaka

Roberts Limited (ZRL), a South African company operating in Johannesburg, to

make the drone production a reality.

Zaka manufactures computer-controlled equipment for university laboratories and

other industries in Africa and the Middle East. It was owned by a group of five

friends who graduated from a South African University and were the directors and

shareholders of the company.

On February 1, 2016 they accepted CRP‟s offer to buy Zaka‟s manufacturing

equipment and technology, which is protected by patent rights, the factory

premises in Cape Town and the head office in Johannesburg for US$450million,

being 75 percent of the value of Zaka. Management notified the employees,

suppliers, customers and other stakeholders that Zaka would cease all

manufacturing undertakings on March 31, 2016.

All employees, apart from a few in the marketing, accounts and administration

departments were rendered redundant, and were given one month‟s notice with

effect from March 31, 2016.

Zaka would now operate under the new name, Chuks Zaka Limited (CZL) from its

former head office in Johannesburg as a marketing company selling CRP‟s drones

in the South African Region. To this effect, CRP will take up 55 percent of CZL, for

which payment was due by February 1, 2017.

Your firm of Chartered Accountants has been the external auditors to CRP and the

company has now engaged your firm to also audit its subsidiary, CZL.


a. Analyse and evaluate the business risks that would be assessed by the

management of CZL. (6 Marks)

b. Analyse and evaluate the business risks that would be assessed by the directors

of CRP. (6 Marks)

c. Assess and advise on the financial statements‟ risks to be considered in

planning the audit of CZL for the year ended December 31, 2016. (8 Marks)

(Total 20 Marks)

111

QUESTION 3

Tophem Bank Nigeria Plc has been operating for 20 years and your firm took over

the audit 5 years ago.

Tophem Bank‟s investment in Accra Insurance Limited, a foreign associate acquired

during the year and accounted for by the equity method, is carried at ₦575 million

on the Statement of Financial Position at December 31, 2016. Tophem‟s share of

Accra‟s net income is included in Tophem‟s income for the year then ended.

However, you were denied access to the management, auditors and the financial

information of Accra Insurance Limited.

Your partner has reviewed the audit file for the year ended December 31, 2016 and

has approved the issuance of a modified opinion. He drew a titular sketch of the

audit report and has asked you to fill up some gaps.

NB: Assume the underlying financial reporting frameworks are applicable to

Tophem Bank Nigeria Plc – Financial Reporting Council of Nigeria Act 2011,

Companies and Allied Matters Act, CAP C20 LFN 2004, International Financial

Reporting Standards, Banks and Other Financial Institutions Act CAP B3 LFN 2004

and other Central Bank of Nigeria guidelines and circulars.


a. Evaluate the circumstance in which a matter could be both material and

pervasive in its effect on the financial statements. (4 Marks)

b. Explain EIGHT of the appropriate procedures to be followed in the audit

assignment before reaching the audit opinion. (8 Marks)

c. Draft appropriate basis of opinion paragraph suitable for inclusion in the

auditor‟s report. (4 Marks)

d. Draft appropriate opinion paragraph suitable for inclusion in the auditor‟s

report. (4 Marks)

(Total 20 Marks)

QUESTION 4

The management of Pony Bank Plc. and its fully owned subsidiary Ponte Micro

Finance Bank Limited arranged and invented bogus loans that totalled N5.5 billion

worthless assets which the former auditors did not detect.

The former auditors claimed that a clique of highly clever and organised swindlers

among the staff of Pony Bank deceived the auditors and devoted themselves to

defeating the audit and covering up their nefarious acts.

112

Your firm of chartered accountants, Vic Viv & Co, has just taken up the audit of Pony

Bank Plc.


a. Advise the engagement partner on the risks involved in taking up the audit.

(4 Marks)

b. Recommend appropriate actions on the part of management and your firm

to overcome the financial statements‟ risks. (8 Marks)

c. Prepare a management letter which includes two matters suitable for

submission to the directors. (8 Marks)

(Total 20 Marks)

SECTION C: YOU ARE REQUIRED TO ANSWER ANY TWO OUT OF THREE QUESTIONS


QUESTION 5

You are the audit manager for XYZ Bank Limited for the year ended December 31,

2016.

From your review of the Bank‟s Board of Directors minutes of meetings, you noted

that during the year, the Board was concerned about a litigation issue involving the

Bank and another company named BBB Limited, in which the Bank is the

defendant.

BBB Limited had sued the Bank for converting a cheque worth N2.1billion and the

high court has declared the Bank guilty and imposed a penalty in the sum of N2.1

billion (i.e. the value of the cheque) on the Bank.

From the available information, it was noted that the claimant (i.e. BBB Limited)

had commenced the process to claim the judgment amount from the Bank.

The Bank was not satisfied with the case and had immediately filed for objection at

the Court of Appeal. The Directors of the Bank, based on the professional legal

counsel obtained, are of the opinion that the judgment issued by the Federal High

Court is baseless and unjustifiable, and that a favourable judgment would be

obtained at the Court of Appeal.

The summary of financial information of the Bank is as follows:

Provision for litigation (already recognised in the Bank‟s financial statements)

N96 million

Number of existing litigation cases as defendant 50 cases

Number of existing litigation cases as plaintiff 10 cases

113

Litigation claims in favour of the Bank N2.7 billion

Litigation claims made against the Bank including the N2.1

billion above N3.2 billion


a. Discuss FOUR of ISA 501 Audit evidence - specific consideration for selected

items requirements on the procedures the auditors can perform to obtain

sufficient and appropriate audit evidence on the litigation provision.

(5 Marks)

b. Comment on the adequacy or otherwise of the amount recognised as

provision for litigation in the financial statements as at December 31, 2016.

(5 Marks)

c. Prepare a summary disclosure of the entity‟s litigation status for inclusion in

the notes to the financial statements as at December 31, 2016. (5 Marks)

(Total 15 Marks)

QUESTION 6

During the course of your audit of fixed assets of Next Engineering Plc at December

31, 2016 two problems arose:

(i) The calculations of the cost of direct labour incurred on assets in the course

of construction by the company‟s employees have been accidentally

destroyed for the early part of the year. The direct labour cost involved is

₦20,000,000.00; and

(ii) The company has received a government grant of ₦50,000,000.00 towards

the cost of plant and equipment acquired during the year and expected to

last for ten years. The grant has been credited in full to the income statement

as exceptional item.

Required:

a. Discuss the general forms of modifications available to the auditors in

drafting their report in accordance with appropriate standards and state the

circumstance in which each form is appropriate. (6 Marks)

b. On the assumption that you decide that a modified audit report would be

necessary with respect to the treatment of government grant, prepare a draft

of the section that deals with the matter (whole report not required).

(5 Marks)

c. Analyse the auditor‟s general responsibility with regard to the statement in

the directors‟ report concerning the valuation of land and building.

(4 Marks)

(Total 15 Marks)

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QUESTION 7

Young Entrepreneur Trading (YET) is an on-line trading business established by

Yemisi Tumfere. The business buys assorted household goods from different

manufacturers locally and abroad. Orders are made on-line from suppliers.

Customers also order goods on-line from YET and their invoices are processed and

transmitted to the store from where the goods are dispatched to the customers

through the delivery stores scattered all over the country.

YET has not been satisfied with the work of the previous auditors and has

approached your firm to be appointed as the new auditors. Appropriate

professional clearance has been resolved for the work to commence. You are the

audit manager responsible for the engagement. You have also been assigned on

the job with some new trainees who are not conversant with controls in on-line

businesses.

Required:

a. Discuss FIVE of the controls an auditor should focus on to assess the

effectiveness of controls in an on-line system such as YET. (5 Marks)

b. Evaluate FOUR risks associated with the business of YET in the application of

electronic data interchange in an on-line business and FOUR effective controls

that may be put in place to minimise the risks. (10 Marks)

(Total 15 Marks)

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SOLUTION I

i. a. The consequences of the poor audit work could be the following:

(i) legal damages and legal costs;

(ii) losing the client;

(iii) adverse publicity and damage to the reputation of the audit

firm;

(iv) disciplinary proceedings by a professional body such as ICAN

(v) loss of high performing employees who would not wish to be

associated with poor image; and

(vi) increased regulatory focus and the associated time lost in

regulatory inspections and reporting

b. The new engagement partner should put procedures in place to ensure

that:

(i) ethical standards are complied with and appropriate action taken

if there is evidence to the contrary;

(ii) independence requirements are met, including:

- identifying circumstances and relationships that might give

rise to threats to independence;

- assessing the impact of breaches of the firm‟s independence

policies and procedures and whether such breaches create a

threat to

- independence; and

- taking suitable action to eliminate identified threats or to

withdraw from the engagement if appropriate.

(iii) the audit is carried out by an audit team with the appropriate

competence and capabilities;

(iv) appropriate management of the engagement is in place, including

the direction and supervision of staff and the review of audit

work;

(v) on or before the date of the audit report, the engagement partner

must, through a review of audit documentation and discussion

with the audit team, be satisfied that sufficient and appropriate

evidence has been obtained to support the conclusions reached.

(vi) adequate consultations have taken place on difficult or

contentious matters and the conclusions from such consultations

implemented;

116

(vii) relevant specialists within the audit firm or experts to be engaged

by the audit team are involved to assist in auditing relevant

difficult areas of the engagement;

(viii) the following matters are documented:

- issues in respect of compliance with ethical requirements and

how they were resolved;

- conclusions on compliance with independence requirements;

- conclusions in respect of new and continuing engagements;

and

- the nature and scope of conclusions from consultations

undertaken.

(ix) Appropriate materiality amount is determined for the financial

statements as a whole and may consider lower performance

materiality at account balance level, in order to focus on high risk

areas and achieve improved audit quality;

(x) An engagement quality control reviewer is appointed and

involved on the engagement to perform an objective evaluation of

the significant judgements made by the audit team, the

conclusions reached and to evaluate the appropriateness of the

audit report;

(xi) Adequate planning of the audit to ensure proper coverage; and

(xii) Review of prior year working papers.

c. The auditor should assess whether it is appropriate to include a deferred tax

asset in the financial statements and so needs evidence about whether the

tax losses will be recoverable. The procedures involved are:

(i) Obtain a copy of the client‟s tax computations and agree the figures in

the calculation to the accounting records. Also consider recalculating

the amount to check it‟s accuracy;

(ii) Review any correspondence about tax that may exist with a view to

verifying the propriety of the tax losses used in the calculation;

(iii) Make an assessment about whether the tax losses will be recoverable,

by obtaining forecasts from the client of future profitability. The

assumptions used in the forecast should be assessed for

reasonableness in the context of the auditor‟s understanding of the

client‟s business;

(iv) If the forecasts of future profitability are reasonable, the auditor should

assess how long it will be before the losses are recovered in full. This

117

period should be checked against tax regulations, to confirm that there is

no statutory limit on carrying forward tax losses;

(v) Determine from the tests above, whether the deferred tax asset should be

recognised in full or whether some amounts should not be fully

recognised; and

(vi) Check that relevant disclosures required in respect of deferred taxes have

been made in the financial statements.

d i Inventories

Important specific audit procedures for inventories include the following:

Evaluation of carrying amount of inventories to ensure that it is stated at

the lower of cost and net realisable value, on an item-by-item basis;

Evaluation of the valuation method used to estimate inventory cost to

ensure that an acceptable method per IAS 2 was used (Remember that

LIFO is not permitted by IAS 2.);

Observe physical count of inventory items;

Obtain evidence that an appropriate method has been used for the

treatment of overheads (overhead absorption);

Check that any obsolete inventory items have been isolated and written

down/off; and

Check that relevant disclosures have been made in the financial

statements in respect of inventories.

(ii) Intangible Assets

Important specific audit procedures for Intangible assets include the following:

Evaluate whether purchased intangible assets have been recognised and

measured in accordance with IAS 38;

Obtain evidence that the useful lives of intangible assets have been

estimated in a reasonable way;

Obtain evidence to support the non-amortisation of intangible assets with an

indefinite useful life where applicable;

Check that intangible assets have been appropriately subjected to annual

impairment reviews and that the resulting adjustments (if any) have been

appropriately determined and recorded;

Evaluate that the relevant disclosures contained in the relevant movement

schedules have been appropriately presented; and

Obtain evidence with respect to disposals during the year and that the

relevant gain or loss has been appropriately recorded in the books.

118

EXAMINER‟S REPORT

The question tests candidates understanding of Audit Quality.

Almost all the candidates attempted the question and performance was average.

MARKING GUIDE MARKS

i. a. 1¼ marks each for any four points 5

B. 1½ marks each for any six points 9

c. 2 marks each for any four points 8

d(i) 1 mark each for any four points 4

(ii) 1 mark each for any four points 4

TOTAL 30

SOLUTION 2

(a) Business risks that will be assessed by CZL‟s management are:

i. The parent company operates in another country with different laws and

regulations;

ii. The parent company operates in high-tech environment and inventories

might be subject to obsolescence, and this will affect the survival of CZL

being a subsidiary;

iii. CZL is now a new company selling items different from its erstwhile

products. New customers would be sought and new marketing efforts

would be employed, yet only skeletal staff were retained;

iv. Staff of Zaka may sue for redundancy costs. Redundancy payments have

not been made. There may be need to make provisions;

v. Possibility of increased errors in processing accounting transactions

because the skeletal staff retained may not allow for segregation of

duties;

vi. The change in line of business will affect after-sales service for customers

of the old company and they may sue for damages;

vii. Receiving products for sale only from its parent company is a limitation

to going concern of the company; and

viii. The parent company is yet to pay for its investment.

119

(b) Business risks that will be assessed by the directors of CRP are:

i. The subsidiary company operates in another country with different laws

and regulations;

ii. The company operates in high-tech environment and inventories might

be subject to obsolescence;

iii. The factory in South Africa may have been acquired at an amount far

more than its value;

iv. The engineering expertise belonged to another company, which had

ceased from existence. It might be difficult getting technical help;

v. Moving from auto parts manufacture to the manufacturing of drones is a

dramatic shift requiring new expertise in manufacturing and sales;

vi. There is need to patronise national carriers and international

organisations like DHL for economically sustainable sales to be attained

since these have had arrangements with airlines for the lifting of mails

and parcels; and

vii. There are no plans yet for the distribution of the products, beyond using

the subsidiary the acquisition of which is yet to be consummated by

making payment.

(c) Financial Statement risks to be considered in planning the audit of CZL

includes:

i. Due to the possibility of rapid obsolescence, inventories in the financial

statements might be overstated. Serious attention needs to be paid to net

realisable value in the valuation;

ii. The worth of the factory in South Africa may have been overstated, as it was

acquired from another company. There is need to do proper valuation of the

net assets acquired so as to determine the right amount of goodwill or

bargain purchase as relevant;

iii. Provision must be made for 55 percent of the value of the subsidiary CZL, (55

percent of US$450 million) payable in February 2017.

iv. There is need to consolidate the accounts of CZL in the financial statements

of CRP;

v. Exchange rate volatility will affect transactions between the company and its

parent company; and

vi. Risk of misstatement of opening balances.

EXAMINER‟S REPORT

The question tests candidates understanding of analysis, assessment and

evaluation of business risks.

About 95% of the candidates attempted the question but performance was poor.

120

Candidates‟ commonest pitfall is lack of understanding of the question.

Candidates are enjoined to use the Institute‟s study text extensively.

Marking Guide

Marks Marks

a Different regulatory environment

High-tech environment

New product

Redundancy payments

Errors in accounting transactions

After sales service

Going concern

Part of company sold on credit

1¼ marks each for

any 4 points

6

b Different regulatory environment

High-tech environment

Over-valued factory

Technical help needed

New expertise

Patronage for product

Distribution of product in other

regions

1¼ mark each for

any 4 points

6

c Valuation of inventories

Valuation of factory

Payment for subsidiary – provisions

Consolidated financial statements

Exchange rate volatility

2 marks each for

any

four points

8

Total 20

SOLUTION 3

(a) Generally, a matter will be material when it impacts the financial/economic

decision of the users of the financial statements.

„Pervasive‟ effects on the financial statements are defined by ISA 705 as

those that, in the auditor‟s judgement:

i. are not confined to specific elements, accounts or items of the financial

statements; or

121

ii. are confined to specific elements in the financial statements, but these

represent (or could represent) a substantial proportion of the financial

statements; or

iii. in relation to disclosures in the financial statements, are fundamental to

users‟ understanding of those statements.

When a „material‟ issue becomes „pervasive‟ then it is significant and affects

substantial proportion of the financial statements. This calls for a modification

of the auditors‟ opinion.

(b) REACHING THE AUDIT OPINION

In reaching his audit opinion, the auditor is required to evaluate whether:

i. He has obtained sufficient appropriate audit evidence as to whether the

financial statements are free from material misstatements;

ii. Uncorrected misstatements are material, individually or in aggregate

iii. The financial statements give a true and fair view;

iv. The financial statements have been prepared in accordance with the

relevant financial reporting framework and in particular whether:

- The financial statements adequately describe the relevant financial

reporting framework;

- The financial statements adequately disclose the entity‟s significant

accounting policies;

- The significant accounting policies are appropriate and consistent

with the relevant financial reporting framework;

- Accounting estimates are reasonable;

- The information in the financial statements is relevant, reliable,

comparable and understandable;

- The financial statements provide adequate disclosures; and

- The terminology used in the financial statements is appropriate.

c. Basis for qualified opinion

Tophem Bank Plc.‟s investment in Accra Insurance Ltd, a foreign associate,

acquired during the year and accounted for by the equity method, is carried

at ₦575 million on the Statement of Financial Position at 31 December 2016.

Tophem Bank Plc‟s share of Accra Insurance‟s net income is included in

Tophem Bank Plc‟s income for the year then ended. We were unable to

obtain sufficient appropriate audit evidence about the carrying amount of

Tophem Bank Plc‟s investment in Accra Insurance Limited at 31 December

122

2016 and Tophem Bank Plc‟s share of Accra Insurance‟s net income for the

year because we were denied access to the management, auditors and the

financial information of Accra Insurance Limited. Consequently, we were

unable to determine whether any adjustments to these amounts were

necessary.

d. Qualified opinion

In our opinion, except for the possible effects of the matter described in the

basis for Qualified Opinion paragraph, the accompanying financial

statements give a true and fair view of the financial position of Tophem Bank

Plc as at 31 December 2016 and the financial performance and cash flows

for the year then ended in accordance with the International Financial

Reporting Standards, the Companies and Allied Matters Act Cap C20 LFN

2004, the Banks and other Financial Institutions Act CAP B3 LFN 2004, the

Financial Reporting Council of Nigeria Act, 2011, and other relevant Central

Bank of Nigeria guidelines and circulars.

EXAMINER‟S REPORT

The question tests candidates understanding of the concept of materiality as

regards financial statements.

About 56% of the candidates attempted the question and performance was poor.

Candidates lacked understanding of the question.

Candidates are advised to prepare adequately for the examination by reading the

Institute‟s study text in detail.

MARKING GUIDE

POINTS TO MENTION Marks Marks

3a Material

Pervasive

Material and pervasive- impact on Audit report

1

2

1

SUB TOTAL 4

3b He has obtained sufficient appropriate audit evidence

as to whether the financial statements are free from

material misstatements

Uncorrected misstatements are material, individually or

in aggregate

1 mark

each for

any 8

points

8

123

The financial statements give a true and fair view

The financial statements have been prepared in

accordance with the relevant financial reporting

framework and in particular whether:

- The financial statements adequately describe the

relevant financial reporting framework

- The financial statements adequately disclose the

entity‟s significant accounting policies

- - The significant accounting policies are appropriate

and consistent with the relevant financial reporting

framework

- Accounting estimates are reasonable

- The information in the financial statements is

relevant, reliable, comparable and understandable

- The financial statements provide adequate

disclosures

- The terminology used in the financial statements is

appropriate

3c Basis of Qualified Opinion – as title

Reference to foreign investment

Unable to obtain appropriate audit evidence

Denied access to the management, auditors and the

financial information

Unable to determine the necessary adjustments

1

1

1

1

1 (Any

four

points)

SUB TOTAL 4

Qualified Opinion – as title

Except for

Reference to Basis of Qualified Opinion

Accompanying financial statements

True and fair view

Name of company

Date of financial statements

Financial Position, Financial Performance & Cash flows

International Financial Reporting Standards

Companies and Allied Matters Act Cap C20 LFN 2004

Banks & Other Financial Institutions Act CAP B3 LFN

2004

Financial Reporting Council of Nigeria Act, 2011

0.25

0.5

0.5

0.25

0.5

0.25

0.25

0.5

0.25

0.25

0.25

0.25

SUB TOTAL 4

Total 20

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SOLUTION 4

a. The engagement partner should take cognisance of the following risks that the

firm could be exposed to, if it takes up the audit:

i. The client‟s working environment has been corrupted with lack of integrity

among staff leading to the creation of non-existent loans;

ii. Internal evidence therefore cannot be relied upon, as they have no weight;

and

iii. The opening balances cannot be relied upon because the financial

statements of prior years have been misstated.

b ACTIONS TO REDUCE THE RISKS

Granted that the business risks are high and that these will create financial

statements risks, the partner must take appropriate actions to reduce their

effects on the financial statements.

The firm must be cautious in dealings with client‟s staff. External evidence

should be used to corroborate whatever internal evidence that would be

presented. Management representation should be obtained, covering

significant matters in the financial statements.

It is important to remember that the firm has taken professional indemnity

insurance. The insurance broker should be notified of this new client and

legal counsel should be obtained.

The specific actions to be taken include the following:

i. Client to conduct an investigation into the activities that created the

fictitious loans;

ii. Do a 100 percent review work on the loans and advances;

iii. Change or modify the accounting package and give new passwords to

new set of staff that would handle the general ledger;

iv. Do a complete overhaul of the credit and marketing department;

v. Stop inter-company loans between the bank and the subsidiary, at

least in the short term. There should be no joint loan syndication

within the Group; and

vi. Obtain further information from culpable staff and block all loopholes.

c MANAGEMENT LETTER

125

Date: 15 April, 2017 Viv Vic & Co

(Chartered Accountants)

The Directors

Pony Bank Plc.

Dear Sir

MANAGEMENT LETTER

We have completed the audit of your Bank‟s financial statements for the year ended

31 December 2016 and we made some observations during the course of the audit.

The observations are presented below.

1. CREATION OF FICTITIOUS ASSETS

Observation

The staff of your bank and the subsidiary Micro Finance Bank colluded and created

bogus loans totalling N5.5 billion over a period of seven years.

Implication

This means that assets have been overstated by N5.5 billion.

Recommendation

There is an urgent need to write off this fictitious asset from the books.

Response

2. BREAKDOWN OF INTERNAL CONTROLS

Observation

The staff of your bank colluded to cover up fraud and gross misstatement.

Implication

This means that the backbone of the internal control system has been broken and it

is difficult to rely on the system for the preparation of the financial statements.

Recommendation

There is an urgent need to overhaul the human resource of the bank. There is need

for thorough investigation and those found culpable should be relieved of their

positions.

126

Response

Conclusion

Please provide a response and action plan for each weakness identified in the

report. This should be inserted in the space provided. Additional sheets could be

attached for further explanation that could help us to serve you better. The contents

of this letter and your response thereupon will be followed up in future audits.

Thank you.

Truly yours,

Engagement Partner.

EXAMINER‟S REPORT

The question tests candidates understanding of audit risks associated with financial

statements.

About 90% of the candidates attempted the question and performance was poor.

Candidates displayed inadequate preparation, and lack in-depth knowledge of audit risks.

Candidates are advised to read the Institute‟s study text thoroughly before attempting the

examination.

MARKING GUIDE


4a Client staff lacked integrity.

Internal evidence cannot be relied upon.

The opening balances cannot be relied upon.

2 marks

each for

any 2

points

SUB TOTAL 4

4b The firm should:

Be cautious in dealings with staff.

Use external evidence to corroborate.

Obtain management representation letter.

Inform Insurance Broker

Client should:

Conduct an investigation into the fictitious loans.

Change or modify the accounting package

New set of staff to handle the general ledger.

Do complete overhaul of credit & marketing

1 mark

each for

any 3

points

1 mark

each for

any 5

127

department.

Do a 100 percent review work on the loans and

advances.

Stop inter-company loans or loan syndication.

Obtain further information from culpable staff

points

SUB TOTAL 8

4c Letter format

Proper Introduction

First observation, Implications, recommendations

Second observation, Implications,

recommendations

Space for management response

Conclusion

Signed by Partner

0.5

0.25

3

3

0.5

0.5

0.25

SUB TOTAL 8

TOTAL 20

SOLUTION 5

(a) ISA 501 states that the auditor shall design and perform audit procedures in

order to identify litigation and claims involving the entity which may give

rise to a risk of material misstatements, including:

i inquiry of management and, where applicable, others within the

entity, including in-house legal counsel;

ii direct communication with the entity‟s external legal counsel. The

auditor shall do so through a letter of inquiry, prepared by

management and sent by the auditor, requesting the entity‟s external

legal counsel to communicate directly with the auditor;

iii reviewing minutes of meetings of those charged with governance and

correspondence between the entity and its external legal counsel;

iv reviewing adequacy of existing litigation provisions;

v) review legal expense account; and

vi) obtain written representation: The auditor shall request management

and, where appropriate, those charged with governance to provide

written representations that all known actual or possible litigations

and claims whose effects should be considered when preparing the

financial statements have been disclosed to the auditor and

128

accounted for and disclosed in accordance with the applicable

financial reporting framework.

(b) The existing provision of N96million is inadequate since it has not

been updated to include the liability arising from the High Court

judgment of N2.1 billion obtained in current year.

The auditor should consider proposing audit adjustment for an

additional N2.1 billion to the existing litigation provision based on the

following:

There is a past event - the relevant past event for the litigation

provision is the event that gives rise to the claim, i.e. the high court

judgment.

The adjusted litigation provision as at 31 December 2016 should then

be N2.196 billion.

(c) Typical disclosure on litigation in the financial statement is presented

below:

“The Bank, in its ordinary course of business, is presently involved in

50 litigation cases as a defendant and 10 cases as a plaintiff. The total

amount claimed in the 10 cases instituted by the Bank is estimated at

N2.7 billion, while the total amount claimed in the 50 cases instituted

against the Bank is N3.2 billion, for which provisions amounting to

N2.196 billion have been made.

The Directors are of the opinion that no other significant liability will

arise therefrom in excess of the provision made in the financial

statements.”

EXAMINER‟S REPORT

The question tests candidates‟ understanding of the specific consideration of

litigation provision of ISA 501- Audit Evidence.

About 65% of the candidates‟ attempted the question but performance was poor.

The commonest pitfall of the candidates was that they applied general knowledge

rather than being specific. They were not familiar with ISA 501 requirement.

The extensive use of the Institute‟s study text is recommended for improved

performance.

129

,MARKING GUIDE

POINTS TO MENTION MARKS

5a. 1¼ marks each for any four points 5

b. - Existing provision of N96m not adequate

- Consider proposing audit adjustment for an additional

N2.1b

- Relevant past event for the litigation provision re High Court

Judgement

- Adjusted litigation provision at 31 December 2016 should be

N2.1966

2

1

1

1

SUB TOTAL 5

c. Mentioning of -

- 50 Litigation cases

- N2.7billion in respect of litigation cases

- Total amount of claim to be N3.2b

- Provision of N2.196b

- Directors opinion that no other significant liability will arise

1

1

1

½

1½

SUB TOTAL 5

TOTAL 15

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SOLUTION 6

a. The general forms of modifications available to the auditors in drafting their

report as stated in ISA 705 are as follows:

Qualified Opinion

This is issued when financial statements are materially misstated, but in the

auditor‟s judgment, the effect of the misstatement is not considered

pervasive.

OR

Issued when the auditor is unable to obtain sufficient appropriate audit

evidence (limitation scope), but in the auditor‟s judgment, the possible effect

of the misstatement is not considered pervasive.

Adverse opinion

Issued when financial statements are materially misstated, and in the

auditor‟s judgment, the effect of the misstatement is pervasive on these

financial statements.

Disclaimer of opinion

Issued when the auditor is unable to obtain sufficient appropriate audit

evidence and the possible effect of the misstatement is material and

pervasive on the financial statements.

b Basis for modified opinion

“As explained in note xx an amount of ₦50,000,000 has been credited to the

Income Statement and included as exceptional items. International Financial

Reporting Standards require that such items should be recognised and

credited to Income Statement over the expected useful economic lives of the

related plant and machinery. The effect of the charge would be to make

operating profit ₦yy

instead of ₦zz

with a corresponding change in

shareholders‟ funds”.

c The directors are solely responsible for the Directors‟ report and the auditors

have no general responsibility for it.

However, they are required to consider whether the information in the

Directors‟ report is consistent with the information in the financial

statements and information they are aware of in the course of their audit.

131

If they are of the opinion that the valuation of land and building are

inconsistent with any information given in the accounts then, they must get

the directors to change that or say so in their report.

This is unlikely, but any information at all in the Directors‟ report which

seems to the auditor as dubious would put the auditor on enquiry.

EXAMINER‟S REPORT

The question tests candidates‟ knowledge on Audit Report on financial statements.

About 45% of the candidates attempted the question, but performance was poor.

The commonest pitfall of the candidates was lack of practical knowledge to be

applied in answering the question.

Constant use of the Institute‟s study text is recommended. Also reading of

published financial statements to get the feel of practical approach is

recommended.

MARKING GUIDE


a. Discussing/indicating when each form is required 2 marks

each for

any three

points

6

b. - The draft of the modification section

- Reference to IFRS

- Reference to appropriation of plant and machinery

- Inclusion of effect on profit

- Description of the error and indication of right

treatment

( 1 mark

each for

any of the

five (5)

points)

5

c. - Disclosure of directors‟ responsibility

- Auditors‟ duty to ensure information is consistent

with financial statements and/or information

already known to the auditor in the cause of the

audit.

- Stating that directors are responsible

- Indicating the action the auditor will take, if

there is inconsistency

Total

1 mark

1 mark

2 marks

4

15

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SOLUTION 7

a) Although on-line systems are usually efficient and effective for the users,

they create additional problems for the auditor who needs to assess the

effectiveness of the system‟s controls. There are two categories of system

controls in an on-line system. These are general and application controls.

General controls in an on-line system could include the following:

i. Access Control - There must be effective controls over access to the

system and its file. This is because in online systems, transactions are

processed as soon as they are inputted;

ii. Software Control -There should be controls written into the system

software to prevent or detect unauthorised changes to programs;

iii. Transaction Log Control - Transaction logs should be used to create an

“audit trail”. The computer program should be written in such a way

as to generate the audit trail for any transaction on request; and

iv. Internet Access Control - Firewalls should be used for systems that

have access to the internet.

Application controls in an on-line system could include the following:

i) Pre-processing authorisation Control - such as logging on to the

system, and the user‟ names and passwords;

ii) Data Validation Control

Data validation checks is the software to check the completeness and

accuracy of processing such as checking that a product code has been

entered with the correct number of digits; and

iii) Balancing Control “Balancing”- checking control totals of data

submitted from remote terminals before and after processing.

b. Electronic Data Interchange (EDI) systems can improve the operational

efficiency of an entity, but they may generate the following problems for the

auditor who has to access the efficiency of the system controls:

i) The lack of proper audit trail;

ii) An increased level of dependency on the computer systems of the

organization and possibly the computer systems of other entities. Any

133

failure or control weakness in one computer system may have an

impact on the computer system that is being audited;

iii) There may be a risk of loss or corruption of data in the process of

transmission; and

iv) There will be security risk in the transmission of data.

Auditors should expect to find effective controls in place to minimise the risk

inherent in EDI systems. Typically, controls will cover such matters as:

i) Control over transmission of data such as the encryption of data

before transmission, acknowledgement systems, and the use of

authentication codes for senders of data;

ii) Monitoring and checking of output;

iii) Virus protection systems; and

iv) Contingency plans and back-up arrangements.

EXAMINER‟S REPORT

The question tests candidates‟ knowledge of on-line real-time business audit.

About 90% of the candidates attempted the question but performance was poor.

The commonest pitfall of the candidates was that their solutions tend towards

controls in a Non-Electronic Data Processing.

Candidates are enjoined to read the question and interpret it correctly before

attempting it. Also, the Institute‟s study text should be used by the candidates in

preparing for future examinations.

Marking Guide

a Any 5 (five) controls, I mark each 5

b Points on operational efficiency -1¼ mark each for four 5

Any 4 (four) controls, 1¼ mark each 5

15

134



CASE STUDY

Time Allowed: 4 hours (including reading time)

INSTRUCTION: YOU ARE TO USE THE CASE STUDY ANSWER BOOKLET FOR THIS

PAPER

TOSTOL DRINKS NIGERIA LIMITED

Requirement

You are Dave Chukwurah, a recently qualified Chartered Accountant and a Junior

Consultant in the firm of Dauda, Eporum, Bala & Co, a firm of consulting accountants

and tax practitioners. One of your Senior Partners, Jaja Eporum, has sent you an email

(Exhibit 1) requiring you to prepare a report to be submitted to Joel Ramsey, Chief

Executive Officer (CEO) of Tostol Drinks Nigeria Limited, one of your clients. Tostol

Drinks Nigeria Limited (TDNL) has requested from your firm an advice in respect of the

company‟s proposed strategic plan aimed at increasing the company‟s shareholders‟

value while at the same time satisfy the company‟s other stakeholders.

The following time allocation is suggested:

Reading 1 hour

Planning and calculations 1 hour

Drafting report 2 hours

4 hours

135

LISTS OF EXHIBITS

EXHIBIT DESCRIPTION

1. Email from Jaja Eporum, a Senior Partner in Dauda, Eporum, Bala

& Co, to you Dave Chukwurah, a Junior Consultant.

2. Email from Joel Ramsey, CEO of Tostol Drinks Nigeria Limited, one

of your clients, to Jaja Eporum.

3. Information on TDNL‟s Business Model and current strategic plan.

4. Five years summarised financial statements of Tostol Drinks

Nigeria Limited.

5. Additional information on TDNL‟s financial statements.

6. Five years summarised financial statements of Brilliant Bottles

Nigeria Limited (BBNL).

7. Additional information on BBNL‟s financial statements.

8. Additional information on the proposed acquisition of Brilliant

Bottles Nigeria Limited.

136

Exhibit 1

Dauda, Eporum, Bala & Co

Chartered Accountants

Email

From: Jaja Eporum – Senior Partner

To: Dave Chukwurah – Junior Consultant

Re: Tostol Drinks Nigeria Limited

Date: April 11, 2017

Further to my discussions with you this morning in my office in respect of our above named

client, I will like you to go through the attachments to this email (Exhibit 2 – 7) and

prepare a report as requested by Joel Ramsey, the Chief Executive Officer (CEO) of Tostol

Drinks Nigeria Limited (TDNL) for my review.

As I made it clear to you, the board of TDNL is concluding the company‟s strategic plan for

the next five years with a central focus on “increase in shareholders‟ value”. The board has

decided to carry out a backward integration by acquiring all the shares of Brilliant Bottles

Nigeria Limited (BBNL). Therefore, the board has asked our firm to carry out a financial

due diligence on the financial statements of BBNL together with additional notes provided.

We are also required to recommend a range of prices that TDNL can offer for the

acquisition.

Further, as part of the input to the strategic plan, TDNL‟s board will want us to review the

company‟s last five years financial statements with a focus on shareholders‟ value analysis

using Economic Value Added (EVA) approach to determine how the company‟s

shareholders‟ value has grown over the years to enable the board set target for the

strategic plan period. The CEO of TDNL has asked us to assume a weighted average cost of

capital of 15% and has availed us with the company‟s financial statements for the last five

years with some additional information.

Required:

Using the attached exhibits, prepare a draft report to Jaja Eporum, your Senior Partner, for

his review before forwarding same to TDNL‟s board. Your report should include:

1. Appraisal of TDNL‟s performance in the past five years based on the company‟s

business model and this should include the additional value added to the

shareholders of TDNL using EVA approach; and

2. A report on the financial due diligence of BBNL to determine its future financial

performance, and whether its acquisition will result in increase in TDNL‟s

shareholders value. You are also to recommend a range of prices that TDNL should

offer to the shareholders of BBNL, based on the share valuation models agreed with

the board of BBNL.

137

Exhibit 2


Email

From: Joel Ramsey – CEO, Tostol Drinks Nigeria Limited

To: Jaja Eporum – Senior Partner, Dauda, Eporum, Bala & Co

Re: TDNL‟s Strategic Plan 2018 – 2022

Date: April 10 2017

Dear Jaja,

Further to my telephone conversation with you this morning, I write to confirm our Board‟s

approval for your firm to assist us in carrying out a financial due diligence for the

acquisition of BBNL which we hope to conclude before the last quarter of the year and also

appraise TDNL performance.

Your firm is required to make input into our strategic plan as follows:

1. Carry out an appraisal of our financial performance in the last five years, taking into

consideration our business model. We need to know how we are faring in respect of

each component of our business model. You are also to determine the value that has

been added to our shareholders in each of the past five years to enable us set targets

for the strategic plan period. You are to use economic value added (EVA) model to

determine value added in those years. I attach herewith our summarised financial

statements for 2012 to 2016 together with some additional information. I also attach

a summary of our business model which is at the heart of our business and also

determines our key performance indicators (KPIs); and

2. In respect of our plan to acquire all the shares of Brilliant Bottles Nigeria Limited, as

a step towards backward integration during the plan period, recommend whether the

acquisition will result in net value added to our present performance. Enclosed

herewith are the company‟s summarised five years financial statements with some

additional information to enable you carry out a financial due diligence on the

company. Your recommendation should also include the range of prices we can offer

to the shareholders of the company.

I hope I can count on you, as usual, to get the report out on time.

Joel Ramsey

CEO, Tostol Drinks Nigeria Limited

138

Exhibit 3


BUSINESS MODEL AND STRATEGIC PLAN

Our vision is “to be a business organisation managed responsibly, sustainably and

with passion for creating value for our shareholders, employees, customers,

consumers and the communities where we do business”.

Our business model is developed along this vision. Our business model therefore, is

to manage our business responsibly, sustainably and delivering superior value to

our shareholders by satisfying our other stakeholders. We believe this will bring

opportunity for superior business growth through our presence in emerging

markets coupled with expanding margins to those achieved in the previous years.

We recognise that creating shared value for shareholders, employees, customers,

consumers and the communities is critical to our long term success. We have

therefore incorporated responsibility and sustainability into all aspects of our

business management, making long term investments that are aimed at building

value over time.

To maintain our consumers in the face of increasing campaign for healthy living,

we have decided to focus on healthy, active lifestyles, while still maintaining our

old range of products, thus significantly broadened our product portfolio by

offering consumers a choice of soft drinks that contains zero sugar and with low

calories. We are also providing more information on our products‟ labels to help

consumers make informed choices between our wide range of product offerings.

Our business model is at the heart of everything we do. It defines the activities we

engage in, the relationships we depend on and the outputs and outcomes we aim

to achieve in order to create value for all our stakeholders in the short, medium and

long term. This is being achieved through constant value creation.

139

VALUE CREATION

We create value for our stakeholders and our business by carefully managing the

use of and return on all capitals or inputs. Also, additional values created are

being shared among the various stakeholders regularly.

VALUE SHARING

By running a profitable, sustainable and responsible business, we are yearly

creating value which is partly retained in the business, making it stronger.

However, the larger part is shared among all our stakeholders as follows:

Shareholders: Through the process of managing all inputs to our business well, we

create value for our shareholders through dividend payments and increase in our

share value.

Suppliers: As we create value, we support businesses throughout our value chain,

and support job creation beyond our business.

Employees: By recognising, developing and rewarding talents of our people, we

secure a skilled and motivated workforce that is remunerated well above the

industry average.

Customers: We strive to produce products‟ efficiently and responsibly thus building

value for our customers‟ businesses.

Consumers: We constantly rejuvenate our products offerings to ensure that our

consumers have a wide range of products to select from while at the same time

making sure they get value for every Naira spent.

Communities: When our business is profitable, sustainable and responsible, the

communities where we operate benefit through job creation, payment of tax to the

governments, useful products and services, and minimisation of environmental

impact. We also consistently invest 3% of our pre–tax profits on programmes to

support communities where our business operates.

All these are aimed at continuous achievement of sustainable growth through

improvement in sales value, market share and profitability.

140

Exhibit 4


SUMMARISED FINANCIAL STATEMENTS 2012 – 2016

Income Statements

Years 2012 2013 2014 2015 2016

N‟m N‟m N‟m N‟m N‟m

Revenue 979.6 1,167.1 1,330.9 1,433.3 1,594.6

Cost of sales (573.7) (665.4) (763.0) (801.0) (839.2)

Gross profit 405.9 501.7 567.9 632.3 755.4

Marketing & distribution expenses (145.3) (188.7) (209.3) (216.9) (259.0)

Administrative expenses (45.5) (53.1) (60.2) (73.4) (76.9)

Finance expenses (3.3) (9.4) (21.5) (47.5) (44.3)

Profit before income tax 211.8 250.5 276.9 294.5 375.2

Income tax expense (17.0) (39.1) (37.9) (22.1) (55.9)

Profit after tax expense 194.8 211.4 239.0 272.4 319.3

Statement of Financial Position

Years 2012 2013 2014 2015 2016


Assets:

Property, plant and equipment 550.2 621.6 658.8 675.1 691.5

Current assets:

Inventories 99.0 87.8 98.5 109.6 108.1

Trade receivables 109.8 134.6 178.8 223.3 244.5

Prepayments 2.6 3.0 3.0 4.0 5.3

Cash and cash equivalents 10.7 38.1 66.5 37.0 129.3

Total current assets 222.1 263.5 346.8 373.9 487.2

Total assets 772.3 885.1 1,005.6 1,049.0 1,178.7

Equity

Share capital 4.0 4.0 4.0 4.0 4.0

Retained earnings 227.0 278.4 325.4 389.8 489.1

Total equity 231.0 282.4 329.4 393.8 493.1

Liabilities:

Long term loans 258.7 235.6 264.7 183.9 125.3

Employee benefit 7.2 10.8 18.2 18.3 23.8

30.7 49.6 60.9 52.7 65.6

141

Deferred tax liabilities

Total non – current liabilities 296.6 296.0 343.8 254.9 214.7

Bank overdraft - 49.5 - 12.4 3.1

Current tax liabilities 23.8 23.5 28.0 34.8 50.4

Short term loans 26.6 34.6 9.5 127.3 171.1

Trade and other payables 191.3 195.4 290.7 220.5 240.1

Provisions 3.0 3.7 4.2 5.3 6.2

Total current liabilities 244.7 306.7 332.4 400.3 470.9

Total equity and liabilities 772.3 885.1 1,005.6 1,049.0 1,178.7

142

Exhibit 5


ADDITIONAL INFORMATION ON FINANCIAL STATEMENTS, 2012 -2016

1. Profit before income tax:

Profit before income tax is stated after charging:

2012 2013 2014 2015 2016


Depreciation 29.9 39.4 48.9 58.0 58.5 59.3

Personnel costs 11.3 13.2 14.5 16.3 18.8

2. Personnel Information:

No of staff 2,168 2,179 2,182 2,245 2,356

Retirements/resignations in the year 20 19 28 32 35

Least paid staff N1.4m N1.6m N1.7m N1.8m N2.0m

3. Social responsibility report:

Expenses on community and

social services during the year N6.0m N8.0m N8.0m N7.5m N7.6m

4. Dividend declared:

During the year (per share) N20.0 N24.0 N26.0 N27.5 N28.0

5. Authorised and issued share capital:

Ordinary share capital of 50 Kobo each 8m 8m 8m 8m 8m

6. Inventories:

Inventories comprise:


Finished goods 10.2 9.4 9.2 8.5 8.6

Raw materials:

Concentrates 30.0 25.2 25.0 32.0 31.0

Sugar 16.0 8.5 14.1 15.5 15.0

Components:

Bottles 40.5 42.3 48.1 50.4 50.5

Crown cocks 2.3 2.4 2.1 3.2 3.0

143

7. Retained earnings is stated after adjusting for dividend paid during the year.

Details of profit after tax and dividend proposed are as follows:

Year Profit after tax Proposed dividend Retained Profit

N‟m N‟m N‟m

2011 160.5 144.0 16.5

2012 194.8 160 34.8

2013 211.4 192.0 19.4

2014 239.0 208.0 31.0

2015 272.4 220.0 52.4

2016 319.3 224.0 95.3

Retained earnings as at December 31, 2011 is N176.2m. Tax rate of 25% is

assumed.

144

Exhibit 6

BRILLIANT BOTTLES NIGERIA LIMITED

SUMMARISED FINANCIAL STATEMENTS 2012 – 2016

Income Statements

Years 2012 2013 2014 2015 2016


Revenue 78.4 82.5 80.6 90.5 101.2

Cost of sales (36.8) (41.2) (39.6) (42.6) (46.2)

Gross profit 41.6 41.3 41.0 47.9 55.0

Marketing & distribution expenses (10.3) (11.5) (12.8) (13.9) (15.2)

Administrative expenses (11.2) (14.8) (15.1) (16.2) (17.0)

Finance expenses (2.0) (3.1) (2.5) (2.1) (1.8)


Income tax expense (3.8) (2.9) (3.6) (5.8) (6.8)

Profit after tax expense 14.3 9.0 7.0 9.9 14.2


Years 2012 2013 2014 2015 2016


Assets:


Current assets:

Inventories 5.0 6.2 6.1 8.9 8.8


Other receivables and prepayment 0.5 0.6 0.9 0.8 0.9

Short term deposit - - 5.0 5.0 12.5



Total assets 25.0 24.9 28.8 31.5 37.5

Equity

Share capital - 50 kobo each 10.0 10.0 10.0 10.0 10.0


Total equity 17.8 18.8 21.1 21.6 25.8

Trade payables 3.2 2.8 3.5 3.6 4.1

Tax liabilities 3.8 2.9 3.6 5.8 6.8

Other payables and accrued

expenses

0.2 0.4 0.6 0.5 0.8


Total equity and liabilities 25.0 24.9 28.8 31.5 37.5

145

Exhibit 7

BRILLIANT BOTTLES NIGERIAL LIMITED

ADDITIONAL INFORMATION ON THE FINANCIAL STATEMENTS: 2012 – 2016

1. Retained earnings:

Retained earnings are stated as follows:

Years 2011 2012 2013 2014 2015 2016

N‟000 N‟000 N‟000 N‟000 N‟000 N‟000

Profit after tax - 14.3 9.0 7.0 9.0 14.2

Dividend paid during the year - 12.1 8.0 4.7 8.5 10.0

Transfer to retained earnings - 2.2 1.0 2.3 0.5 4.2

Retained earnings B/F - 5.6 7.8 8.8 11.1 11.6

Retained earnings C/F 5.6 7.8 8.8 11.1 11.6 15.8

2. Tax expense:

Tax expense as calculated is settled on preceding year basis. The company

has no outstanding tax liability other than the current year tax liability which

is payable the following year. However, the Federal Inland Revenue Service

(FIRS) carried out an audit of the company‟s income tax liabilities from 2011

to 2015 and came up with an additional tax liability of N10.5m. The company

has objected to this tax liability within the stipulated time but the issue has

not been resolved. No provision has been made in the financial statement of

2016 for this liability. It is projected that the final liability will be N8.5m.

3. Personal income tax liability:

The state government carried out tax audit on the company for 2015 and 2016

personal income tax liabilities. Additional liabilities of N1.45m and N1.02m

have been raised. The company has objected to these liabilities but

reconciliation meeting has not been held with the tax authority. Based on the

company‟s tax consultant‟s assessment, the final liabilities are expected to be

N0.8m and

N0.65m for the two years respectively.

4. Contingent liability:

Apart from the specific potential liabilities mentioned, the company has no

other contingent liability.

146

Exhibit 8

ADDITIONAL INFORMATION ON THE PROPOSED ACQUISITION OF

BRILLIANT BOTTLES NIGERIAL LIMITED

1. Purchase consideration:

The acquisition will be done through payment of cash. TDNL is not under any

obligation whatsoever to absorb any of the existing directors of BBNL.

2. Valuations:

From the preliminary discussions with the board of BBNL, the company will

accept a valuation of the average of the net assets per share and 5 years profit

after tax with a growth rate of 10 percent per annum. The average profit for

the last five years is to be taken as the annual maintainable profit.

3. Fair value of BBNL:

The fair value of BBNL‟s property, plant and equipment is agreed to be N15m

while all other assets and liabilities are considered to worth their book values.

4. Benefits of the acquisition to TDNL:

The following benefits are projected to be accruable from the proposed

acquisition:

a. It is estimated that the current BBNL‟s plant and machinery will meet

TDNL‟s bottle requirements for the next five years. However, TDNL will

make additional investment in plant and machinery of N15m to acquire

a recycling plant to recycle used bottles in line with TDNL‟s business

model of environmental responsible business practice; and

b. It is projected that the acquisition will reduce the cost of bottles of TDNL

by 25 per cent. The cost of bottles in TDNL‟s cost of sales is currently 20

per cent.

147

5. Appraisal of the investment in BBNL:

Although the proposed acquisition of BBNL is part of the current strategic plan

of TDNL, the directors of TDNL want assurance that this acquisition will result

in increase in the company‟s shareholders‟ value. The board has therefore

agreed to evaluate this acquisition with a cost of capital of 15% as calculated

by TDNL‟s Chief Financial Officer (CFO). The CFO has also provided the

following additional information:

a. The savings from the cost of bottles should be based on the average cost

of bottles for the last five years with a growth rate of 12 per cent per

annum in the next five years which is the estimated life of BBNL‟s

production plant; and

b. The residual value of BBNL‟s production plant is estimated to be N1.2m.

148

ICAN CASE STUDY 2017

First Marking

DATE CADIDATE NO.

DATE MARKER NUMBER

SUPERVISOR

SIGNATURE

CHECKER

SIGNATURE

Change made?

Req 1 Req 2 Overall TOTAL

SA

CA

BC

NC

V

Total 8 8 4 20

149

REQUIREMENT 1 - TDNL's financial analysis and shareholders' value added.

USES DATA AND INFORMATION APPROPRIATELY

IDENTIFIES ISSUES AND OPTIONS

Uses information provided in Exhibit 1

Identifies that industry comparative data is not

provided.

Uses information provided in Exhibit 2

Identifies that TDNL's market share is not provided.

Uses information in financial statements .

Identifies that the market size of the soft drinks

industry is not provided

.

Uses information provided in Exhibit 5 -

additional information

Identifies that TDNL's position vis -a- vis its competitors

in the market is not provided.

Uses information in exhibit 3 - information on

TDNL's business model

Identifies that TDNL's competitive profile is not

provided.

V

NC BC CA SA

V

NC BC CA SA

USES PROFESSIONAL TOOLS AND KNOWLEDGE

APPLIES PROFESSIONAL SCEPTICISM AND ETHICS

Calculates profitability ratios

Recognises that we are not told whether the

summarised financial statements is from the

audited accounts of TDNL.

Calculates activity ratios

Recognises that we cannot determine whether the rate

of growth in TDNL's operating performance is due to

general increase in the market size or due to TDNL's

operational efficiency.

Prepares trend analysis to determine growth in

performance of TDNL

Recognises that we do not have the industry average

figure to determine whether TDNL's performance is

above the industry average or below it.

Prepares common size analysis to show trends

in the components of the financial statements.

Recognises that we do not have the indication on the

movement in TDNL's share value.

-

V

NC BC CA SA

V

NC BC CA SA

USES ANALYTICAL SKILLS (material points)

written report

EVALUATIVE SKILLS AND JUDGEMENT

Determines the rate of growth in TDNL's operating

performance.

Recognises that TDNL's performance is increasing

yearly.

Determines the key performance indicators

relevant to the various aspect of TDNL's

business model

Recognises that TDNL has followed its business model

by taking care of all the stakeholders.

Understand the concept of economic value

added (EVA).

Recognises that TDNL has a high dividend pay out

ratio.

Determines the level of economic value added

to TDNL's shareholders from 2012 to 2016.

Recognises that as a result of the high dividend payout

ratio, the company has to result to long term

borrowing to finance its growth.

V

NC BC CA SA

V

NC BC CA SA

150

CONCLUSIONS

(Draws distinct conclusions under a heading)

Concludes on the level of growth of shareholders'

value

Concludes on the need to manage receivables

very well to avoid bad debts and excessive cost of

funds.

TDNL should try to pay its supplier as at when

due so that they will not lose confidence in the

company.

Concludes on shareholders' value analysis.

V

NC BC CA SA

RECOMMENDATIONS (commercial / relevant)

TDNL should continuously seek improvement in

operatioanal performance.

TDNL should find out what other firms in the

industry

are doing so as to know how to respond to

competition.

TDNL should continue with its business model.

TDNL should strive to reduce cost of sale as much as

possible.

If possible, TDNL should reduce its dividend payout

ratio to provide funds for further expansion without

borrowing.

V

NC BC CA SA

SA

CA

BC

151

NC

V

152

REQUIREMENT 2 -Financial Due Diligence of BBNL

USES DATA AND INFORMATION

APPROPRIATELY

IDENTIFIES ISSUES AND OPTIONS

Uses BBNL's financial statements - Exhibit 6

Need to consider the state of BBNL's

manufacturing plants.

- Income Statement

- Statement of financial position

Uses additional information on BBNL's financial statement-

Need to consider how to integrate BBNL's staff into

the culture of TDNL.

Exhibit 7.

Uses information in email provided in Exhibit 1

Need to consider trade unions issues.

Uses information in email provided in Exhibit 2

Need to consider how to raise fund required to pay

off the shareholders of BBNL.

Uses information provided in additional points on the

proposed acquisition - Exhibit 8 Need to consider non-financial factors

V

NC BC CA SA

V

NC BC CA SA

USES PROFESSIONAL TOOLS AND KNOWLEDGE (written

into report)

APPLYING PROFESSIONAL SCEPTICISM AND

ETHICS

Performs appropriate calculation to determine BBNL's

net assets

Considers whether the summarised financial

statement is from the audited accounts of BBNL

Performs appropriate calculation to determine the value

of BBNL based on five years maintainable earnings.

Considers the correctness of the estimated tax

payable on the two tax audits.

Prepares expected cash flow from the acquisition by TDNL.

Considers the maintenance culture of BBNL on its

manufacturing plant.

Recognises the treatment of potential liabilities of the

tax audits.

Ensures that other analysis & evaluation are

considered

Calculates the savings expected from the cost of bottles on

TDNL's operations.

Considers whether all the shareholders of BBNL

will agree to the acquisition.

Considers the correctness of the cost of capital

to be used for the appraisal and other estimates

-

V

NC BC CA SA

V

NC BC CA SA

USESG ANALYTICAL SKILLS (material points)

EVALUATIVE SKILLS AND JUDGEMENT

(uses analytical headings)

Calculates appropriate ratios.

Considers the costs required to finalise the

acquisition.

Prepares trends analysis of BBNL's financials. Considers use of other appraisal methods

Prepares common size analysis of BBNL's financials.

Questions use of cost of capital - could be higher?

lower? how derived?

Calculates the net present value of cash flows to determine

whether the acquisition is worthwhile.

Considers likely savings in BBNL's operating costs

because of the acquisition.

Considers the response of competitors to this

acquisition.

153

V

NC BC CA SA

V

NC BC CA SA

CONCLUSIONS

(Draws distinct conclusions under a heading)

Concludes on net assets value of BBNL.

Concludes range of prices to be offered to the

shareholders of BBNL.

Concludes on other financial factors not considered

Concludes on other non-financial factors

Concludes on whether the acquisition will add value to

the shareholders of TDNL.

V

NC BC CA SA

RECOMMENDATIONS (commercial / relevant)

Recommends the range of prices to be offered for BBNs

Shares.

TDNL should consider the accuracy of all the estimates

used.

Determines and recommends whether to go on with the

acquisition based on the appraisal.

TDNL should determine the cost involved in the

acquisition so as to consider it as part of the cash flow in

the appraisal pricess.

The acquisition of BBNL will increase the shareholders'

valu so TDNL so TDNL should proceeed.

V

NC BC CA SA

SA

CA

BC

NC

V

Total 8

155

Appendices

Main Report

Appendices R1: Content and style

Report: Structure

Shows TDNL financial ratios.

Sufficient appropriate headings

Shows the TDNL's trend analysis

Appropriate use of paragraphs /

sentences

Shows TDNL's common size financial

statements. Legible

Shows the economic value added for

each year. Correctly numbered pages

V

NC BC CA SA

V

NC BC CA SA

Appendices R2: Content and

Report: Style and language

Shows the valuation of BBNL based on net

assets. Relevant disclaimer (external report)

Shows the valuation of BBNL based

on 5 years maintainable earnings. Suitable language for the board

Shows the range of prices to be

offered to BBNL's shareholders. Tactful / ethical comments

Shows the net present value

calculations. Acceptable spelling and punctuation

Shows the financial ratios of BBNL.

V

NC BC CA SA

V

NC BC CA SA

CC

SC

IC

ID

NA

Total

Tostol Drinks Nigeria Limited

Trend Analysis - 2012 - 2016

Income Statement

YEARS 2012 2013 CHANGE

2014 CHANGE

2015 CHANGE

2016 CHANGE

N'm N'm N'm % N'm N'm % N'm N'm % N'm N'm %

Revenue 979.6 1,167.1 - 187.5

-

19.1 1330.9

163.8 14.0 1433.3 102.4 7.7 1594.6 161.3 11.3

Cost of sales - 573.7 - 665.4 91.7

-

16.0 -763

(97.6) 14.7 -801.0 -38.0 5.0 -839.2 -38.2 4.8

Gross Profit 405.9 501.7 - 95.8

-

23.6 567.9

66.2 13.2 632.3 64.4 11.3 755.4 123.1 19.5

-

Marketing & Distribution expenses - 145.3 - 188.7 43.4 - 29.9 -209.3

(20.6) 10.9 -216.9 -7.6 3.6 -259 -42.1 19.4

Administrative expenses - 45.5 - 53.1 7.6 - 16.7 -60.2

(7.1) 13.4 -73.4 -13.2 21.9 -76.9 -42.1 57.4

Finance expenses - 3.3 - 9.4 6.1 - 184.8 -21.5

(12.1) 128.7 -47.5 -26.0 120.9 -44.3 -84.2 177.3

Profit before income tax 211.8 250.5 - 38.7

-

18.3 276.9

26.4 10.5 294.5 17.6 6.4 375.2 -126.3 -42.9

Income tax expenses - 17.0 - 39.1 22.1 - 130.0 -37.9

1.2 -3.1 -22.1 15.8 -41.7 -55.9 -33.8 152.9

Profit after income tax expenses 194.8 211.4 - 16.6 - 8.5 239.0

27.6 13.1 272.4 33.4 14.0 319.3 46.9 17.2

Statement of Financil Position

2012 2013 CHANGE

2014 CHANGE

2015 CHANGE

2016 CHANGE

N'm N'm N'm % N'm N'm % N'm N'm % N'm N'm %

Assets:

Property, plant and equipment 550.2 622 71 13.0 658.8

37

6.0 675.1 16.3 2.5 691.5 16.4 2.4

Current assets:

Inventories 99 87.8 - 11

(11.3) 98.5

11

12.2 109.6 11.1 11.3 108.1 -1.5 -1.4

Trade receivables 109.8 134.6 25 22.6 178.8

44

32.8 223.3 44.5 24.9 244.5 21.2 9.5

Prepayments 2.6 3 0 15.4 3

-

- 4 1 33.3 5.3 1.3 32.5

Cash and cash equivalents 10.7 38.1 27 256.1 66.5

28

74.5 37 -29.5 -44.4 129.3 92.3 249.5

Total current assets 222.1 263.5 41 18.6 346.8

83

31.6 373.9 27.1 7.8 487.2 113.3 30.3

Total assets 772.3 885.1 113 14.6 1005.6

121

13.6 1049 43.4 4.3 1178.7 129.7 12.4

Equity:

Share capital 4 4 0

- 4 0

- 4 0 - 4 0

-

Retained earnings 227 278.4 51.4

22.6 325.4 47

16.9 389.8 64.4 19.8 489.1 99.3

25.5

158

Total equity 231 282.4 51.4

22.3 329.4 47

16.6 393.8 64.4 19.6 493.1 99.3

25.2

0

Liabilities:

0

Long term loans 258.7 235.6 -23.1 - 8.9 264.7 29.1

12.4 183.9 -80.8 - 30.5 125.3 -58.6 - 31.9

Employee benefir 7.2 10.8 3.6

50.0 18.2 7.4

68.5 18.3 0.1 0.5 23.8 5.5

30.1

Deferred tax liabilities 30.7 49.6 18.9

61.6 60.9 11.3

22.8 52.7 -8.2 - 13.5 65.6 12.9

24.5

Total non - current liabilities 296.6 296 -0.6

-

0.2 343.8 47.8

16.1 254.9 -88.9 - 25.9 214.7 -40.2

-

15.8

Bank overdraft 0 49.5 49.5

0 -49.5 - 100.0 12.4 12.4

3.1 -9.3 -75.0

Short term loans 23.8 23.5 -0.3 - 1.3 28 4.5

19.1 34.8 6.8 24.3 50.4 15.6

44.8

Trade and other payables 26.6 34.6 8

30.1 9.5 -25.1

-

72.5 127.3 117.8 1,240.0 171.1 43.8

34.4

Provisions 191.3 195.4 4.1

2.1 290.7 95.3

48.8 220.5 -70.2 - 24.1 240.1 19.6

8.9

Total current liabilities 3 3.7 0.7

23.3 4.2 0.5

13.5 5.3 1.1 26.2 6.2 0.9

17.0

Total equity and liabilities 244.7 306.7 62

25.3 332.4 25.7

8.4 400.3 67.9 20.4 470.9 70.6

17.6

772.3 885.1 112.8

14.6 1005.6 120.5

13.6 1049 43.4 4.3 1178.7 129.7

12.4

Tostol drinks Nigeria Limited

Common Size Analysis 2012 – 2016

Income Statement

2012 2013 2014 2015 2016

Revenue 100.0 100.0 100.0 100.0 100.0

Cost of sales - 58.6 - 57.0 - 57.3 - 55.9 - 52.6

Gross Profit 41.4 43.0 42.7 44.1 47.4

- - - - -

Marketing & Distribution expenses - 14.8 - 16.2 - 15.7 - 15.1 - 16.2

Administrative expenses - 4.6 - 4.5 - 4.5 - 5.1 - 4.8

Finance expenses - 0.3 - 0.8 - 1.6 - 3.3 - 2.8


Income tax expenses - 1.7 - 3.4 - 2.8 - 1.5 - 3.5

Profit after income tax expenses 19.9 18.1 18.0 19.0 20.0


2012 2013 2014 2015 2016

Assets:


Current assets:

Inventories 12.8 9.9 9.8 10.4 9.2


159

Prepayments 0.3 0.3 0.3 0.4 0.4



Total assets 100.0 100.0 100.0 100.0 100.0

Equity:

Share capital 0.5 0.5 0.4 0.4 0.3


Total equity 29.9 31.9 32.8 37.5 41.8

Liabilities:

Long term loans 33.5 26.6 26.3 17.5 10.6

Employee benefir 0.9 1.2 1.8 1.7 2.0

Deferred tax liabilities 4.0 5.6 6.1 5.0 5.6

Total non - current liabilities 38.4 33.4 34.2 24.3 18.2

Bank overdraft - 5.6 - 1.2 0.3

Short term loans 3.1 2.7 2.8 3.3 4.3


Provisions 24.8 22.1 28.9 21.0 20.4



100.0 100.0 100.0 100.0 100.0

160

RATIOS ANALYSIS 2012 2013 2014 2015 2016

PROFITABILITY

Gross profit margin 405.9/979.6% 501.7/1167.1% 567.9/1330.8% 632.3/1433.3% 755.4/1594.6%

41.44% 43.00% 42.70% 44.10% 47.40%

Net profit margin 211.8/979.1% 250.5/1167.1% 276.9/1330.8% 294.5/1433.3% 375.2/1594.6%

21.60% 21.50% 20.80% 20.50% 23.53%

Returns on total assets 211.8/772.3% 250.5/885.1% 276.9/1005.6% 294.5/1049.0% 375.2/1178.7%

27.40% 28.30% 27.50% 28.00% 31.80%

Returns on capital employed (ROCE) 215.1/527.6% 259.9/578.4% 298.4/673.2% 342.0/648.7% 419.5/707.8%

40.80% 44.90% 44.40% 52.70% 59.30%

Returns on equity 194.8/231.0% 211.4/282.4% 239.0/329.4% 272.4/393.8% 319.3/493.1%

84.30% 74.90% 72.60% 69.20% 64.80%

LIQUIDITY

Current ratio 222.1/244.7 263.5/306.7 346.8/332.4 373.9/400.3 487.2/470.9

0.9:1.0 0.9:1.0 1.0:1.0 0.9:1.0 1.0:1.0

Quick ratio 123.1/244.7 175.7/306.7 248.3/332.4 263.3/400.3 129.3/470.9

0.5:1.0 0.6:1.0 0.7:1.0 0.7:1.0 0.8:1.0

cash ratio 10.7/244.7 38.1/306.7 55.5/332.4 37.0/400.3 129.3/470.9

00:01.0 0.1:1.0 0.2:1.0 0.1:1.0 0.3:1.0

ACTIVITY

Net assets turnover 979.6/527.6 1167.1/578.4 1330.9/673.2 1433.3/648.7 1594.6/707.8

1.9 2 2 2.2 2.3

Fixed assets turnover 979.6/550.2 1167.1/621.6 1330.9/658.8 1433.3/675.1 1594.6/691.5

1.8 1.9 2 2.1 2.3

Total assets turnover 979.6/772.3 1167.1/885.1 1330.9/1005.6 1433.3/1049.0 1594.6/1178.7

1.3 1.3 1.3 1.4 1.4

Inventory turnover 573.7/99 665.4/93.4 763.0/93.2 801.0/104.1 839.2/108.9

5.8 7.1 8.2 7.7 7.7

Average days inventory 365/5.8 365/7.1 365/8.2 365/7/7 365/7.7

63days 51days 43days 47days 47days

Receivable turnover 979.6/109.8 1167.1/122.2 1330.9/156.7 1433.3/201.1 1594.6/233.9

8.9 9.6 8.5 7.1 6.8

Average days in receivable 365/8.9 365/9.6 365/8.5 365/7.1 365/6.8


Payable turnover

573.7/191.3 665.4/193.4 763.0/243.1 801.0/255.6 839.2/230.3

3 3.4 3.1 3.1 3.6

Average days in payable 365/3.0 365/3.4 365/3.1 365/3.1 365/3.6


SOLVENCY

Debts to equity 296.6/231.0 296.0/282.4 343.8/329.4 254.9/393.8 214.7/493.1

1.28 1.05 1.04 0.65 0.44

Debts/equity+debts 296.6/527.6 296.0/578.4 343.8/673.2 254.9/648.7 214.7/707.8

0.56 0.51 0.51 0.39 0.3

Interest cover 215.1/3.3 259.9/9.4 298.4/21.5 342.0/47.5 419.5/44.3

65.2 27.6 13.9 7.2 9.5

Personnel ratios

Staff turnover 20/2168 19/2179 28/2182 32/2245 35/2356

0.90% 0.90% 1.30% 1.40% 1.50%

161

Average profit after tax per staff 194.8/2168 211.4/2179 239.0/2182 272.4/2245 319.3/2356

N0.09m N0.10m N0.11m N0.12m N0.14m

average salary per staff N1.4m N1.6 N1.7m N1.8m N2.0m

Social responsibility report( % of pre tax profit) 6/211.8% 8/250.5% 8/276.9% 7.5/294.5% 7.6/375.2%

2.83% 3.19% 2.90% 2.55% 2.03%

2012 2013 2014 2015 2016

CALCULATION OF ECONOMIC VALUE ADDED N'm N'm N'm N'm N'm

Calculation of NOPAT

Net profit after tax 194.8 211.4 239 272.4 319.3

Add: Interest expenses (net of taxation) 2.24 6.39 14.62 32.3 30.12

197.04 217.79 253.62 304.7 349.42

CAPITAL EMPLOYED 527.6 578.4 673.2 648.7 707.8

Cost of capital at 15% 79.1 86.8 101 97.31 106.17

Adjusted Net profit after tax 197.04 217.79 253.62 304.7 349.42

Less: cost of capital 79.1 79.1 86.8 101 97.31

Economic value added 117.94 138.69 166.82 203.7 252.11

NOTE:

Usually, the opening capital is used to calculate cost of capital, but because we were not given the opening

capital for 2012, we have used the closing capital for 2012 caculation while for other years we used opening capital.

162

APPENDICE TO REQUIREMENT 2

Brilliant Bottles Nigeria Limited

Trend Analysis - 2012 - 2016

Income Statetement

YEARS 2012 2013 CHANGE

2014 CHANGE

2015 CHANGE

N'm N'm N'm % N'm N'm % N'm N'm % %

Revenue

78.4 82.5

4.1

5.2

80.6 - 1.9 - 2.3 90.5 9.9 12.3 11.8

Cost of sales

-

36.8 - 41.2

-

4.4

12.0

-

39.6 1.6 - 3.9 - 40.6 - 1.0 2.5 13.8

Gross Profit

41.6 41.3

-

0.3

-

0.7

41.0 - 0.3 - 0.7 47.9 6.9 16.8 14.8

Marketing & Distribution expenses

-

10.3 - 11.5

-

1.2

11.7

-

12.8 - 1.3 11.3 - 13.9 - 1.1 8.6 9.4

Administrative expenses

-

11.2 - 14.8

-

3.6

32.1

-

15.1 - 0.3 2.0 - 16.2 - 1.1 7.3 4.9

Finance expenses

-

2.0 - 3.1

-

1.1

55.0

-

2.5 0.6 - 19.4 - 2.1 0.4 - 16.0 - 14.3

Profit before income tax

18.1 11.9

-

6.2

-

34.3

10.6 - 1.3 - 10.9 15.7 5.1 48.1 33.8

Income tax expenses

-

3.8 - 2.9

0.9

-

23.7

-

3.6 - 0.7 24.1 - 5.8 - 2.2 61.1 17.2

Profit after income tax expenses

14.3 9.0

-

5.3

-

37.1

7.0 - 2.0 - 22.2 9.9 2.9 41.4 43.4

Statement of Financil Position

2012 2013 CHANGE

2014 CHANGE

2015 CHANGE

N'm N'm N'm % N'm N'm % N'm N'm % %

Assets:

Property, plant and equipment 15.0 13.5

-

1.5

-

10.0

12.0 - 1.5 - 11.1 10.5 - 1.5 - 12.5 - 14.3

Current assets:

Inventories 5.0 6.2

1.2

24.0

6.1 - 0.1 - 1.6 8.9 2.8 45.9 - 1.1

Trade receivables 3.0

2.8

-

0.2

-

6.7

3.2 0.4 14.3 5.1 1.9 59.4 - 9.8

Short term deposit -

-

-

5.0 5.0

5.0 - -

Other receivables and

prepayments 0.5

0.6

0.1

20.0

0.9 0.3 50.0 0.8 - 0.1 - 11.1 12.5

Cash and cash equivalents 1.5

1.8

0.3

20.0

1.6 - 0.2 - 11.1 1.2 - 0.4 - 25.0 41.7

Total current assets

10.0

11.4

1.4

14.0

16.8 5.4 47.4 21.0 4.2 25.0 35.7

Total assets

25.0

24.9

-

0.1

-

0.4

28.8 3.9 15.7 31.5 2.7 9.4 19.0

163

Equity:

Share capital

10.0

10.0

- -

10.0 - - 10.0 - - -

Retained earnings

7.8

8.8

1.0

12.8

11.1 2.3 26.1 11.6 0.5 4.5 36.2

Total equity

17.8

18.8

1.0

5.6

21.1 2.3 12.2 21.6 0.5 2.4 19.4

Liabilities:

Trade and other payables

3.2

2.8

-

0.4

-

12.5

3.5 0.7 25.0 3.6 0.1 2.9 13.9

Tax liabilities

3.8

2.9

-

0.9

-

23.7

3.6 0.7 24.1 5.8 2.2 61.1

Other payables and acrued

expenses

0.2

0.4

0.2

100.0

0.6 0.2 50.0 0.5 - 0.1 - 16.7 60.0

Total current liabilities

7.2

6.1

-

1.1

-

15.3

7.7 1.6 26.2 9.9 2.2 28.6 18.2

Total equity and liabilities

25.0

24.9

-

0.1

-

0.4

28.8 3.9 15.7 31.5 2.7 9.4 19.0

164

Common size Analysis - 2012 – 2016

Income Statement

YEARS 2012 2013 2014 2015 2016

N'm

N'm

Revenue 100.0 100.0 100.0 100.0 100.0

Cost of sales - 46.9 (49.9) - 49.1 - 44.9 (45.7)

Gross Profit 53.1 50.1 50.9 52.9 54.3

- - - -

Marketing & Distribution expenses - 13.1 (13.9) - 15.9 - 15.4 (15.0)

Administrative expenses - 14.3 (17.9) - 18.7 - 17.9 (16.8)

Finance expenses - 2.6 (3.8) - 3.1 - 2.3 (1.8)


Income tax expenses - 4.8 (3.5) - 4.5 - 6.4 (6.7)

Profit after income tax expenses 18.2 10.9 8.7 10.9 14.0


2012 2013 2014 2015 2016

Assets:


Current assets:

Inventories 20.0 24.9 21.2 28.3 23.5


Short term deposit - - 17.4 15.9 33.3

Other receivables and prepayments 2.0 2.4 3.1 2.5 2.4



Total assets 100.0 100.0 100.0 100.0 100.0

Equity:

Share capital 40.0 40.2 34.7 31.7 26.7


Total equity 71.2 75.5 73.3 68.6 68.8

-

Liabilities:

-


Tax liabilities 15.2 11.6 12.5 18.4 18.1

Other payables and accrued expenses 0.8 1.6 2.1 1.6 2.1



165

2012 2013 2014 2015 2016

RATIOS ANALYSIS

PROFITABILITY

Gross profit margin 41.6/78.4% 41.3/82.5% 41.0/80.6% 47.9/90.5% 55./101.2%

53.10% 50.10% 50.90% 52.90% 54.30%

Net profit margin 18.1/78.4 11.9/82.5 10.6/80.6 15.7/90.5 21./101.2%

23.10% 14.40% 13.20% 17.20% 20.80%

Returns on total assets 18.1/25% 11.9/24.9% 10.6/28.8% 15.7/31.5% 21.0/37.5

72.40% 47.80% 36.80% 49.80% 56.00%

Returns on capital employed (ROCE) 20.1/17.8% 15/18.8% 13.1/21.1% 17.8/21.6% 22.8/25.8%

112.90% 79.80% 62.10% 82.40% 88.40%

Returns on equity 14.3/17.8% 9.0/18.8% 7.0/21.1% 9.9/21.6% 14.2/25.8%

80.30% 47.90% 33.25% 45.80% 55.00%

LIQUIDITY

Current ratio 10/7.2 11.4/6.1 16.8/7.7 21.0/9.9 28.5/11.7

1.4:1 1.9:1 2.2:1 2.1:1 2.4:1

Quick ratio 5.0/7.0 5.2/6.1 10.7/7.7 12.1/9.9 19.7/11.7

0.7:1.0 0.9:1.0 1.4:1.0 1.2:1.0 1.7:1.0

cash ratio 1.5/7.2 1.8/6.1 6.6/7.7 6.2/9.9 14.2/11.7

0.2: 1 0.3:1.0 0.9:1.0 0.6:1.0 1.2:1.0

ACTIVITY

Net assets turnover 78.4/17.8 82.5/18.8 80.6/21,1 90.5/21.6 101.2/25.8

4.4 4.4 3.8 4.2 3.9

Fixed assets turnover 78.4/15 82.5/13.5 80.6/12 90.5/10.5 101.2/9.0

5.2 6.1 6.7 8.6 11.2

Total assets turnover 78.4/25.0 82.5/24.9 80.5/28.8 90.5/31.5 101.2/37.5

3.1 3.3 2.8 2.9 2.7

Inventory turnover 36.8/5 41.2/5.6 39.6/6.1 42.6/7.5 46.2/8.8

7.4 7.4 6.5 5.7 5.3

Average days inventory 365/7.4 365/7.4 365/6.5 365/5.7 365/5.3


Receivable turnover 78.0/3.0 82.5/2.9 80.6/3.0 90.5/3.6 101.2/4.8

26 27.4 28.9 25.1 21.1

Average days in receivable 365/26 365/27.4 365/28.9 365/25.1 365/21.1


Payable turnover 36.8/3.2 41.2/3.0 39.6/3.1 42.6/3.6 46.2/3.8

11.3 13.3 12.8 11.8 12.2

Average days in payable 365/11.3 365/13.3 365/12.8 365/11.8 365/12.2


SOLVENCY

Liabilities/total assets 7.2/25 6.1/24.9 7.7/28.8 9.9/31.5 11.7/37.5

0.3 0.2 0.3 0.3 0.3

166

BBNL VALUATION REPORT

1 Average net assets per share:

Nm

Total assets at fair value N(15+ 28.5)

43.50

Less liabilities 11.70

Potential tax liabilities:

CIT 8.50

PIT 1.45

21.65

21.85

No of shares in issue

20,000,000

Net assets per share

21,850,000/20,000,000

N1.09

2 Five years average profit

Average profit: Nm

2012 14.3

2013 9

2014 7

2015 9.9

2016 14.2

54.4 54.4/5 N10.88m

annual maintainable profit: Nm

year 1 10.88

year 2= 10.88x 1.1 11.968

year 3= 11.968 x 1.1 13.165

year 4 = 13.165 x 1.1 14.481

year 5= 14481 x 1.1 15.929

66.423

Less contingent liabilities: 9.950

56.473

No of shares in issue 20,000,000

Price per share 56.473/20.0

N2.82

TDNL should offer between N1.09 t0 N2.82 per share.

APPRAISAL OF INVESTMENT IN BBNL

Purchase consideration N21.85m or N56.473m

New plant N15.0m

Cash inflow for five years: Year Cost of salesCost of bottles Savings

20% 25%

Nm Nm Nm

2012 573.7 114.74 28.685

2013 665.4 133.08 33.27

167

2014 763 152.6 38.15

2015 801 160.2 40.05

2016 839.2 167.84 41.96

Total savings

182.115

Average savings

182.115/5 N36.423m

Annual growth rate:

N36.423m

Year 0

Year 1 36.423 x 1.12

N40.794

Year 2 40.794 x 1.12

N45.689

Year 3 45.689 x 1,12

N51.172

Year 4 51.172 x 1.12

N57.312

Year 5 57.312 x 1.12

N64.19

Year cash flow DCF NPV

Nm

Nm

Purchase of BBNL 0 -21.85 1 -21.85

Purchase of new plant 0 -15 1 -15

Savings on cost of bottles 1 40.794 0.8696 35.474





Residual value of plant 5 1.2 0.4972 0.597

132.098

If the purchase price of BBNL is N2.82 per share, then the NPV will be:

132.098 - (56.473 - 21.850)

N97.475m

174

EXAMINER‟S REPORT

There are two requirements the candidates are expected to address in their report

on the case. The requirements are:

(a) Evaluation of Tostol Drinks Nigeria Limited‟s operating performance, taking

into consideration the company‟s business model and economic value added

to its shareholders; and

(b) Financial due diligence on Brilliant Bottles Nigeria Limited to determine

whether it is worthwhile to acquire it or not. Candidates are expected to

calculate net present value to determine post-acquisition additional value

that will be added to Tostol Drinks Nigeria Limited.

To be able to write a good report and perform very well in the paper, candidates

are expected to prepare the following appendices:

(a) Relevant financial ratios for Tostol Drinks Nigeria Limited, including trend

analysis, taking into consideration the company‟s business model;

(b) Calculation of economic value added for Tostol Drinks Nigeria Limited, from

2012 to 2016;

(c) Relevant financial ratios for Brilliant Bottles Nigeria Limited, including trend

analysis for 2012 to 2016;

(d) Valuation of Brilliant Bottles Nigeria Limited based on net assets basis and

average maintainable earnings; and

(e) Net present value calculation to show the effect of the acquisition on the

performance of Tostol Drinks Nigeria Limited.

Candidates‟ performance was poor as only few candidates scored 50% or above.

The candidates pitfalls are:

(a) Lack of proper understanding of the requirements of the case;

(b) Inability to correctly calculate economic value added of Tostol Drinks Nigeria

Limited;

(c) Inability to calculate correctly the appropriate performance ratios for Tostol

Drinks Nigeria Limited based on its business model;

(d) Inability to carry out correct valuation of Brilliant Bottles Nigeria Limited

based on the two indicated valuation models;

175

(e) Inability to calculate appropriate ratios correctly;

(f) Inability to understand how to generate figures required to calculate the net

present value from the financial data provided; and

(g) Inability to write a good report with appropriate headings and subheadings.

(h) Poor communication skill of the candidates.

Candidates are advised to go through the previous examinations‟ pathfinders

and appraise themselves with the examiner‟s comments so as to properly

understand how to approach Case Study examination. Also, candidates

should come to terms with the fact that all the knowledge and skills they

have gained in the subjects of previous examinations would be needed while

dealing with Case Study examination.

pathfinder - icanig.org · 2018. 2. 20. · november 2017 diet professional level examinations...

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